Question

* Problems: be sure to include any steps that support your answer for partial points. * When you draw a graph to show a model, be sure to label: i. the axes; ii, the curves: iii. the in values: iv. The direction curves shift and v. the terminal equilibrium values. 1. The Fed decides to reduce the discount rate. (13pts) 1) What would happen to the interest rate? Use a model to explain your answer. (5pts) 2) What kind of monetary policy does the Fed conduct here? Explain. (2pts) 3) What would happen to GDP and inflation? Use a model to explain your answer. (6pts)

Answer 1

1) There has been a reduction in the discount rate. This is the rate at which the Fed gives loans to commercial banks. Now with lower discount rate, commercial banks will be able to make out more loans which is likely to increase money supply. As the money supply is increased in the asset market / money market, the money supply curve shifts right lowering the rate of interest.

Real interest rate M$1 MS2 NMD M/P1 M/P2 Money balances (real)

2) It is an expansionary monetary policy because it is expected to raise investment and aggregate demand and so expand economic activity

3) GDP is increased because then in the goods market, AD will be shifting to the right. However, the inflation rate also increases because some of the multiplier effect is mitigated due to upward sloping AS curve.

AS Price level G* G1 Real output