Question

I. Monetary Policy For each of the event below, show the short-run effects on output, price and unemployment and explain how the Fed should adjust the money supply and interest rates to stabilize output A. FED increases the money supply to stimulate economy from recession. B. FED increased the fed fund rate from 0.25 to 1.25% to fight against the potential high inflation rate. C. Without any intervention by FED, people holds more cash and banks hold more excess reserves due to market uncertainty

Answer 1

1. a) When the FED increases money supply to recover from a recession , output increases because increase in money supply means more aggregate demand and production . Prices rise due to rise in AD . Unemployment decreases due to more spending in investments . The FED should decrease the interest rate to increase the money supply . When the interest rate falls , the cost of borrowing money declines , so investment expenditure rises in the economy . The AD curve shifts right in short run causing the real GDP to rise from recession and reach potential .

b) Federal funds rate is the rate of interest at which banks rend reserve balances to another bank on overnight basis . So increasing this rate causes this loan to be costlier . Hence banks borrow less from each other . This is a tight money policy which reduces money supply in the economy causing AD to fall , output falls , price level falls ( inflation rate falls ) . Unemployment increases due to fall in AD .

c) In this situation the FED should decrease interest rate and stimulate the economy by stimulating investment . Decreasing interest rate causes investments to rise and people find holding money less lucrative . So money supply automatically increases and economic growth is accelerated which restores certainty in the economy . Output , price level , employment rises .