Question

1. List and explain the 3 tools of Federal Reserve Monetary Policy. 2. Explain how the Federal Reserve would use expansionary monetary policy to close a recessionary gap. Explain how the money supply, interest rate, investment spending, consumer spending, aggregate demand, real GDP, unemployment, and price level is affected. Illustrate this graphically below

Answer 1

When there is a recessionary gap, real GDP is less than potential GDP. In that scenario, monetary expansion can bring the economy back to its long run equilibrium. An expansionary monetary policy is aimed at reducing the rate of interest which increases the access to credit by economic agents. When the Fed buys bonds, it increases the demand for bonds which increases its price. This reduces the interest rate on bonds. Banks have more excess reserves now so they reduce the rate of interest on loans and borrowing is increased. Hence, an increased money supply results in a lowering of rate of interest. This increases consumer and investment spending which stimulates aggregate spending. Thus, AD shifts to the right till the new equilibrium is achieved. Both the level of employment and real GDP are higher and unemployment is lower. Prices are increased during the transition