Question

Suppose a rise in consumer confidence causes aggregate demand to increase, resulting in a short-run equilibrium that is above the equilibrium levels of full employment output and the equilibrium target price level for the Fed. What type of monetary policy might the Fed use to reduce inflationary pressures and to bring the economy back to full employment? Describe the transmission channel from the Fed’s primary method of conducting monetary policy to spending in the economy.

Answer 1

To reduce the inflationary pressure in the economy the Fed will use the contractionary monetary policy, they can increase the discount rate, increase the reserve requirement, and sell the bonds in the market. The primary policy method for the Fed is to increase the discount rate in the market.

A higher discount rate will make the borrowing costlier for the banks in the market, at a higher borrowing price the interest rate for the borrowers from the bank will rise. At high interest rate the investment will decrease thereby reducing the employment and income of the people. At a lower income the demand will be low and it will shift the AD curve to the left i.e. at a lower price and lower output. This will decrease the inflation in the market.

answered by: anonymous