Question

Suppose that the US Federal Reserve Board was able to confirm that the US economy is in the brink of a recession, operating at a GDP level (Y1) that is well below its full-employment capacity (YF). Your tasks are:

5.1. Name one monetary policy, and specify the policy tool to use, that the Fed could make to help boost the economy.

5.2.Using the AD-AS theory, show and EXPLAIN the expected short run and long run effect of this policy on the US economy. Other things are assumed constant. Explain which curves shift and why. Label curves clearly. Identify the new equilibrium in the short-run and the long-run.

Answer 1

Initially the equilibrium was at point A where AD1 and SRAS1 intersected and the output level was below the potential GDP level which was causing recessionary gap in the economy. In short run Fed try to raise the money supply in the economy through open market operations and buying bonds from the market which will raise money to the public. As money supply is raised in the economy, that will raise the aggregate GDP which shifts from AD1 to AD2 and making the new equilibrium at point B at potential GDP level. In long run producers get to know the actual demand for products in the economy and raises the supply to the market to satisfy all the demand in the market which shifts the supply curve to its right from SRAS1 to SRAS2 and making a new equilibrium there at point C where prices come down at the initial level at the output is more than the potential level which causes the inflationary gap in the economy.