Question

I really need help with these two I do not understand the theory and how to illustrate these on diagrams

Suppose you were a member of the Federal Reserve Board of Governors: a. What three policies would you suggest to combat inflation? Why? Explain carefully. b. Using money market diagrams illustrate and briefly explain the effects of your suggested open market operations. Suppose that the Fed's policy objective is to keep the nominal interest rate constant. How would a Fed with this policy objective respond to an increase in money demand? Use money market diagrams to illustrate your answer.

Answer 1

Fig. below shows inflationary gap where aggregate demand has shifted right from AD1 to AD2. Price levels also go up from Pf to PLe. Real GDP goes up from Yf to Ye. Real GDP is more than potential GDP of Yf.

During an inflationary level, govt. can adopt contractionary fiscal policy(Raising tax rates and decreasing govt. spending) and central bank can have contractionary monetary policy ( raising interest rates and lowering money supply ).

Inflationary gap correction needs AD 2 to be shifted back to AD1.Contractionary monetary policy will decrease borrowing by people and investments by businesses as cost of borrowing goes up. Higher interest rates also encourage savings and hence AD2 shifts to AD1. This will reduce economic activity and needed result will be achieved.

This policy is a widely used policy by central banks all over the world to correct inflation. It may create unemployment but is largely successful as it can take place without time lags and does not create crowding out effect.

Price leve Pe 2ea

b. Contractionary monetary policy: Money supply As shown in diagram b below, central bank can aim at a certain interest rate (say i2 and hence it will decrease money supply from Q2 to Q1. Figure a above shows that at less interest rate money demand is more.

Effect on output and interest rate. An increase in interest rates is done with an intention to lower consumer and business borrowing and hence spending (lower Consumption and Investments ), and therefore shift AD to the left as shown in fig. 1 above. Output decreases and interest rates increase.

Effect on equilibrium consumption and investment: Consumption and investments decrease as borrowing becomes costlier.

mete sm gats rate 쇼2- 2.3

If Fed wants to keep interest rates constant then they can increase money supply through open market operations ( Buying govt. bonds and securities) or can temporarily change reserve ratio so that banks can lend more money to people. As shown in the diagram b above, supply of money can be shifted to right at same interest rates (say i2 ).