Question

If LRAS = $500 billion, RGDP = $700 billion, and MPC = .8, then what should the Fed do? Be specific and list all three options. Also draw and label both the current situation and what would occur as the government impacted the economy through their actions.

What are the impacts in the short run of the above actions on the following: the market interest rate, the quantity of money demanded, investment spending, aggregate demand, potential output, the price level, and equilibrium RGDP.

Answer 1

Here economy is operating above the full employment. The full employment level is 500. While economy is operating at the 700 which is above the full employment.

Thus here federal reserve must follow the contractionary monetary policy here :

• Open market operation: the federal reserve will sell the government securities in the open market and it would increase the interest rate by causing decrease in the money supply.
• Reserve ratio: the reserve ratio will be increased , it will increase interest rate as the money supply will be declined.
• Increase in the fedeal fund rate: the increase in the federal fund rate would increase the interest rate.

Thus the constractionary monetary policy would shift the aggregate to down thereby leading to fall in the output, and price level while the rate of interest will rise in the economy.