Question

Answer any 5 questions out of the following 7 questions.

1) When the economy is close to or at full employment why is it difficult for the Fed to decide whether or not to change its interest rate target in the federal funds market?

2) Explain why monetary policy makers believe that it is important to start restraining growth in aggregate demand before there is a noticeable increase in the CPI.

3) Draw an AS-AD diagram to illustrate the effects of rising inflation expectations on an economy threatened by inflationary growth in aggregate demand. Explain your diagram clearly.

4) Explain why expansionary monetary policy may be relatively ineffective and slow in helping an economy recover from a serious recession

5) Draw an AS-AD diagram to illustrate the results of a successful expansionary monetary policy.

6) Assume that workers, employers and investors all believed that inflation in the coming year would equal the annualized rate of inflation experienced in the past 6 months. Also assume that workers had been receiving nominal wage gains of 5% during a several year period where the annual inflation rate was 2%. and worker productivity growth was 3% per year. Now assume that a decline in the unemployment rate below NAIRU creates conditions where workers push for an annual real wage increase of 4%. Also assume that labor productivity growth declines to 1% per year as unemployment is squeezed below normal frictional & structural levels.

a) what rate of nominal wage growth will workers seek at the new low unemployment rate?

b) how fast will firms have to raise prices given your answer in (a) in order to protect profit margins?

c) if the rate of inflation in (b) occurs and the Fed allows AD to grow fast enough to maintain the unemployment rate below NAIRU for another year, what rate of nominal wage growth will workers seek in the following year?

d) if the rate of inflation in (b) had persisted for 6 months or more, how large an increase in the federal funds rate would be needed to increase the level of real interest rates in the economy?

7) Is the Fed currently pursuing an expansionary, neutral, or contractionary monetary policy? What if any difficulties do you think may be encountered in implementing the current policy being pursued by the Fed to cope with current dilemma on its next action at the point of close to full employment of the economy?

Answer 1

1) When the economy is close to full employment or working at potential output any change in the FED rate can destabilize the economy. from a potential output point if the Fed decides to increase the rates it will decrease the potential investment and bring the demand in the economy down. If the Fed decides to decreases the rates it will increase the money supply in the market and with it, demand will increase causing inflation in the economy.

Because of the above-mentioned scenario, it becomes difficult for the FED to decide if they want to change the rates when the economy is close to full employment.

2) A noticeable increase in the CPI means people are demanding much more than the supply in the economy can provide. Seeing an excess demand firms will tend to hire more and increase the production if the FED acted at that time it will be difficult for the firms to rollback their expanded operations and will cause unnecessary troubles. But, if the fed acted on time i.e. when the CPI rates are just started to increase then they can keep it down and manage easily with small changes in the interest rates unlike the time of increased rates when they will be forced to make big changes in the interest rates destabilising the market and investments in the economy.

3)

  

In the graph shown above, the economy was initially at an equilibrium at point E*. At this point, the price is P and output is Y'. The Short-run aggregate demand curve and short-run aggregate supply curve meet at this point with the long run aggregate supply curve.

From this point, the inflation creeps in and the SRAD shifted to SRAD1 increasing the output and price in the economy. The new equilibrium is at point E'.

4) At the point of the serious recession, the economy might fall into a liquidity trap. The liquidity trap can be defined as a point where the demand for the money is much more than what the fed is providing. So, people just keep the excess liquidity with themselves. This makes the expansionary monetary policy ineffective in the time of recession.

5)

The above graph shows the effect of the expansionary monetary policy, it increased the demand and moved the SRAD curve to SRAD1 increasing the demand and price in the economy.