Question

With a large and growing deficit, the Federal Reserve may face pressure from the federal government to enact monetary policy. What monetary policy would the federal government want the FED to enact in response to an increase in government debt? What is the tradeoff of this monetary policy?

Answer 1

With a growing deficit, the Federal government will pressure the Federal Reserve to follow expansionary monetary policy which involves printing of new money in the economy which will increase the level of money supply and reduce rate of interest and thus reduce cost of loans and also helps banks in financing the federal deficit of Deficit Financing. Thus, when the government is in deficit, then it forces Federal Reserve to follow expansionary monetary policy.

This increase in the money supply will not led to increase in the level of production in the economy and will only increase the level of demand without corresponding increase in production and thus creates inflation in the economy because demand is created but corresponding production is not created in the economy.Thus, inflation will occur and this is the trade off of this monetary policy.