Question

Suppose you are recommending monetary policy. The economy is experiencing a sharp and prolonged inflationary trend.

a. What change in open market operations would you recommend?

b. Explain how the change you advocate would affect the cash rate

c. Explain how the change you advocate would affect the cost and availability of credit

d. Use diagrams/graphs of the money market and also AD-AS to support your discussion

Answer 1

Answer A.

Since the economy is in an inflationary gap, the monetary policy that needs to be pursued is contractionary monetary policy. The open market operation during contractionary monetary policy would be to sell bonds in the open market.

Answer B.

When the federal reserve sells bonds in the open market, the banks and financial institutions buy the bonds and this absorbs liquidity from the banking system.

With a relatively tight liquidity scenario, banks have less excess reserves than before. The cash rate is the rate at which banks lend to each other on an overnight basis. Since liquidity becomes tight and banks have relatively less excess reserves, the cost of money trends higher and therefore the cash rate increases.

Answer C.

When inter bank lending rate increases, the banks have to pay other banks higher interest on any overnight loans. Therefore, the overall cost of funds for the banks increases. In other to maintain a healthy net interest income margin, the banks increase the interest rate that is charged to consumers and businesses.

Further, tight money supply in the banking system itself implies higher cost of available money as the supply of loanable funds declines with demand remaining the same.

Answer D.

The first chart shows the AS-AD model with the economy in an inflationary gap when the aggregate demand curve is represented by AD1. During an inflationary gap, the output is Y1, which is higher than the potential output and the price level is at P1. When contractionary monetary policy is pursued and interest rates trend higher, leveraged consumption and investment spending in the economy declines. This translates into relatively lower economic growth and the aggregate demand curve shifts to the left to AD. This shift takes the economy back to potential output and the output declines to Y with price levels declining to P.

The second chart gives the market for loanable funds with the initial supply and demand curve represented by S and D respectively. When the federal reserve sells bonds and liquidity in the banking system declines, the supply of loanable funds also declines. The supply curve shifts to the left from S to S1. This translates into interest rates increasing from i to i1 and the quantity of loanable funds demanded declining.