Question

What action can the Federal Reserve take to reduce unemployment?  

Using one of the tools available to the Federal Reserve, explain how the Fed would accomplish the action you listed.

Assume the economy is currently operating at the natural rate of unemployment, what affects will the action you listed in response to have in the short run on output, price level, and interest rates?  Please use the AS/AD and Money Market diagrams to illustrate your answer.

Again, assume the economy is currently operating at the natural rate of unemployment, what affects will the action you listed in response to have in the long run on output, price level, and interest rates?  Please use the AS/AD and Money Market diagrams to illustrate your answer.

Answer 1

Fed can reduce the level of unemployment in the economy by increasing money supply or following expansionary monetary policy because it increases aggregate demand and thus increase output and increase labor demand which reduces unemployment level of the economy. It can be done by reducing reserve requirement, reducing banks rate or discount rate or by purchasing government securities in the open market.

Let the economy is initially at point E1 in money market and AS-AD diagram. Purchasing of government securities by the Fed will shift the money supply curve rightwards to Ms' in the money market and thus at new equilibrium point E2, rate of interest has declined. This decline in the rate of interest increases investment expenditure and thus increases aggregate demand shifting the AD curve rightwards to AD' and thus at new equilibrium price level has risen and output has increased in the economy to OY2 reducing unemployment rate in the economy.

In the long run, this will reduction in unemployment rate will increase wage rate and thus cost of production increases which shifts the SRAS curve leftwards to SRAS' and thus new equilibrium occurs at point E3 where price level has risen to OP3 and output has reached its potential level.

Thus, in long run only price level is impacted with change in money supplied.