Question

** Please answer all parts and explain!

1. Assume the economy is currently experiencing a recessionary gap.

a. How should the Fed use the three monetary policy tools to close this gap? (0.6 point)

b. What will happen to money supply, AD, AD curve, aggregate output (real GDP), and the price level when the above policy tools are used? Explain. (0.6 point)

2. a. What is the equation of exchange? (0.1 point)

b. What does the quantity theory of money predict about the effect of an increase in money supply on the overall economy in the long run? (0.1 point)

Answer 1

Question 1.

A)  Monetary policies can be used to remove the recessionary gap in the economy. There are mainly three types of monetary policy which fed can use to increase the money supply in the market and increase the purchasing power of the economy.

(i) Open market operation :- Where fed buy securities from the market to inject the money in the market.

(ii) Reserve requirement :- Fed will lower the reserve requirement for banks so that banks can lend more money into the market and money supply will increase.

(iii) Discount rates :- Discount rate is charged by the fed from the commercial bank for short term loans. Fed will lower the discount rate which leads to lower of interest rate which is charged by bank for lending loans into market.

B) Due to the above policies:-

Money supply :- It will increases in the economy.

Aggregate demand :- It will increases as economy has increased purchasing power.

AD curve :- Aggregate Demand curve will shift to the upward right side.

Aggregate output :- Due to increase in aggregate demand overall aggregate output is also increases in the economy to match the demand requirement of the economy.

Price Level :- Price level also increases due to initial effect of higher demand and lower supply in the market.  

Question 2.

A) Equation of exchange shows the relation between money supply and price level , and GDP and Money supply.

Money supply * Velocity of money = Price level * Real GDP

It shows that money supply and price level of the economy has direct relation in the short run. Since in short run Velocity of money and overall output remain constant in the economy.

B) In the long run Velocity of money and real GDP will not remain same. If the money supply is increases then due to higher velocity and increase in the real output in the long run overall price level is also increases. Which leads to higher economic growth in the economy in the long run. ( Higher demand and Higher supply )