Question

8% inflation rate and a 6% growth rate. What kind of economy is that if we are talking about a large, developed economy like the US (overheating or recessionary)? What should the Fed do? What is their concern in this type of economy (unemployment or inflation)? How would the Fed use its tools to try to correct this problem?

Can you tell us which specific ways the Fed would engage in contractionary monetary policy? Would they buy or sell Treasuries and how would that action affect the money supply and interest rates?

Answer 1

The economy is an overheating economy because it has characteristics of high inflation and high growth rate. This happens when the economy grows at higher than it's potential output and the growth rate is unsustainable. Suppliers are not able to meet the demand and this leads to increase in prices. An overheating economy has feature of close to full-employment. Thus, higher prices lead to higher wages and the price-wage spiral starts

Thus, the economy in question is an overheating economy.

The Fed should take contractionary policies to cool down the economy, I.e to reduce the aggregate demand in the economy.

The concern for Fed in this type of economy is inflation, not unemployment because in an overheating economy, the unemployment rate is below the natural rate of unemployment.

Fed will use it's monetary tools to decrease the money supply in the economy and increasing interest rates. An increase in interest rate would lead to cut down in the aggregate spending, the investment spending as well as consumer spending will decrease. This would cool down the economy.

The Fed would use open market operations to decrease the money supply in the economy.

To decrease the money supply in economy, the FFed would sell the treasury bills in the market. So that money from the economy comes to Fed and money supply decreases.

The decrease in money supply would lead to increase in interest rates.