Question

Make the answer as short as possible, please.

Assume that the economy is currently in short run equilibrium but experiencing a recessionary gap:

1. Graphically illustrate the problem
2. Identify the combination of monetary policies that the Federal Reserve would pursue to correct problem
3. Graphically illustrate and explain how these monetary policies affect the market for reserves, the market for M1, and the market for real goods and services (AD-AS)
4. Make sure that you identify the Fed’s goals/objectives and also graphically illustrate the solution.

Answer 1

Following the graphical depiction of the recessionary gap:

LRAS SRAS Price Level Aggregate Demand Recessionary Gap Real GDP

Under the recession, the economy operates below the full potential level. The aggregate demand is not enough to produce at the level of full employment.

Federal reserve will go with cheap monetary policy to correct the disequilibrium in the economy. The Federal fund rate would be reduced, further open market operation of the Fed would be the most successful tool in driving the up the aggregate demand.  Fed will buy the securities from the open market thereby new money will be injected into the market.

The supply of M1 and Reserve will rise. Now banks will be able to make more loans to the public and interest rates will be low.

Following will be effects on the aggregate demand:

LRAS SRAS Price Level New AD Aggregate Demand Recessionary Gap Real GDP

In above diagram, the expansionary monetary policy will drive up the aggregate demand and AD curve will shift to the right. Now new equilibrium is established where LRAS = NEW AD. it would be full employment condition.

Fed has twin responsibilities: full employment and price stability. Thus, after reaching the full employment level, now Fed would try to restrict the further rise in the price level.