Question

1. The U.S. Bureau of Economic Analysis and the Federal Reserve Bank have just released the latest data on the American economy. Actual real GDP is now $18.2 trillion, while the latest estimate of potential real GDP is $17 trillion. The rate of unemployment is now 3.2%, while the rate of inflation is 9.5%. If the Federal Reserve Bank engages in countercyclical monetary policy, what would the Federal Reserve Bank do? Explain what open market operation the Fed would use and the monetary transmission mechanism.

2. In 1896, American politician William Jennings Bryan made a speech at the Democratic National Convention in which he stated “You shall not crucify mankind on a cross of gold.” He was arguing in favor of increasing the American money supply to help farmers, who were heavily in debt. Why would in-debted farmers be in favor of substantially increasing the money supply? Who would be hurt by his policy?

Answer 1

Q1) SInce the actual real GDP = $18.2 trillion is greater than the potential GDP = $17 trillion as well as extremely high inflation and extremely low unemployment, it is clear that the economy is overheated. Since the monetary policy is countercyclical, the Fed would want to increase the interest rate (contractionary monetary policy). They will increase the federal funds rate through open market operations. the Fed will have to decrease the money supply to increase the interest rate. They can achieve this by selling government securities through open market operations. This reduces the liquidity available in the banking system and the money supply falls. Thus, the interest rates will rise making it difficult for firms and individuals to borrow and thus will slow down the economy.