Question

Use economic theories and terminologies you learned to analyze and explain the questions step by step. A single strong paragraph (not less than 200 words) for each question should be sufficient as long as it is done well.

How does monetary policy affect equilibrium GDP? How can it address the problem of recession or slow growth? How can it address the problem of inflation (demand-pull)?

Answer 1

Monetary policy refers to controlling the money supply. An increase in the money supply decreases interest rates, which increases consumption and investment. The increases in consumption and investment increase aggregate demand, which increases the equilibrium level of real GDP. A decrease in the money supply increases interest rates, which decreases consumption and investment. The decreases in consumption and investment decrease aggregate demand, which decreases the equilibrium level of real GDP.

Monetary policy attempts to reduce the fluctuations in nominal GDP and unemployment by manipulating the rate of growth in the money supply. Monetary policy is carried out by Federal Reserve Bank’s open market committee. The general strategy is to increase money growth during periods of higher unemployment (recession) and reduce money growth during periods of inflation (excess expansion)

Monetary policy attempts to increase aggregate demand during recession by increasing the growth of the money supply. The theory of liquidity preference suggests that increasing the money supply will cause interest rates to fall. Lower interest rates cause higher investment spending which increases aggregate demand. When the Federal Reserve Bank increases the money supply through an open market operation, it is buying government bonds from large banks with newly created reserves. The additional reserves allow the banks to create new money through loans to private citizens and companies. As banks compete to make new loans, they will offer loans at lower interest rates. The new lower interest rates attract new borrowers. Most borrowers are using the loans to purchase durable items such as cars, houses, or – in the case of companies – new factories and equipment. As a result,

One popular method of controlling inflation is through a contractionary monetary policy. The goal of a contractionary policy is to reduce the money supply within an economy by decreasing bond prices and increasing interest rates. This helps reduce spending because when there is less money to go around, those who have money want to keep it and save it, instead of spending it. It also means that there is less available credit, which can also reduces spending. Reducing spending is important during inflation, because it helps halt economic growth and, in turn, the rate of inflation.

There are three main tools to carry out a contractionary policy. The first is to increase interest rates through the central bank, in the case of the U.S., that's the Federal Reserve. The Fed Funds Rate is the rate at which banks borrow money from the government, but, in order to make money, they must lend it at higher rates. So, when the Federal Reserve increases its interest rate, banks have no choice but to increase their rates as well. When banks increase their rates, fewer people want to borrow money because it costs more to do so while that money accrues at a higher interest. So, spending drops, prices drop and inflation slows.

The second tool is to increase reserve requirements on the amount of money banks are legally required to keep on hand to cover withdrawals. The more money banks are required to hold back, the less they have to lend to consumers. If they have less to lend, consumers will borrow less, which will decrease spending.

The third method is to directly or indirectly reduce the money supply by enacting policies that encourage reduction of the money supply. Two examples of this include calling in debts that are owed to the government and increasing the interest paid on bonds so that more investors will buy them. The latter policy raises the exchange rate of the currency due to higher demand and, in turn, increases imports and decreases exports