Question

Assume an economy is in an inflationary gap in the AD/AS model, with an exceptionally low unemployment rate and an alarming rising inflation rate. Discuss the three major monetary policy tools available to the Federal Reserve, how they are likely to use them in order to address the issue, and the anticipated impact this would have on the economy (real GDP, the unemployment rate, and the inflation rate). In what way can unexpected changes to the velocity of money lead to unanticipated outcomes?

Answer 1

Answer - The following three measures are available with fed -

1 - The increae in reserve requirement will decrease the excess reserves of the banks and thus they will be able to lend lesser amount and money supply will decrease.

2 - By selling the government securities in open market , the government can take the money out of circulation in economy.

3 - The increasing the discount rates , it will make borrowing more expensive for the banks. Banks will able to lend lesser amount then and money supply will decrease.

These tools will lead to the decrease in the money supply in the economy . It will increase the rate of unemployment , reduce inflation and price levels. The real GDP will also fall

The increase in the velocity of money suddenly increases the demand and the price level in the economy and the reverse effect is seen in case of decrease in velocity.