Question

Question 1: Monetary Policy

Suppose the economy is in an inflationary gap, and the Fed responds by conducting a

contractionary monetary policy.

a. Explain what the Fed does if it conducts open market operations to control inflation.

b. Explain the effects of this monetary policy on interest rates, business investments,

consumption expenditures, the value of the U.S. dollar, and the value of net exports.

Answer 1

Inflationary gap in an economy induce Fed to adopt contractionary monetary policy.

a) Fed will sell government securities and bonds into the market and accept cash in exchange of it from investors. It will reduce circulation of money from the economy and reduce money supply.

b)

Rise in rate of interest will reduce investment because it will raise the cost of borrowing for investors.

Reduction in money supply will reduce willingness to pay for goods and reduce aggregate demand of goods which will reduce consumption expenditure.

Rise in rate of interest will appreciate the U.S. dollar which will raise the cost of importing goods for any customer outside the U.S. market. It means it will reduce exports of U.S. and raise imports which in turn reduces net exports.