Question

Assume the economy is in an inflationary gap.

A. What action should the Fed take to try to move the economy back to long run equilibrium? Is this contractionary or expansionary monetary policy?

B. Briefly explain how this action by the Fed would affect the economy as a whole (AD/AS). Use graphs to illustrate your explanation.

Answer 1

a) In case of an inflationary gap, the Fed will have to reduce the money supply. It will increase the interest rates and reduce the investment in the economy. The reduced investment will reduce the demand and bring the inflation under control. This will be called contractionary monetary policy.

b) In the graph shown above, the economy was at equilbrium at point "a", which is more than the potential output level because of which the economy will experience inflation. From this point, the FED will use contractionary fiscal policy which will shift the Aggregate demand curve to the left, the new curve will be SRAD1. The new equilibrium will be at point "b" at a lower output and lower price.