Question

The Federal Reserve faces an expansionary gap. How would you expect it to respond? Explain step by step how its policy change is likely to affect the economy.

Answer 1

An expansionary gap is when output is more than potential level.

'The FEd reserve must undertaken a contractionary monetary policy by:

1. Increasing reserve rate or
2. Selling government bonds

3. Increasing bank rate

This would lead to decrease in the money supply. So the interest rate will rise and investmetn will fall. As a result, AD will shift in and the output level will decrease to potential GDP. The price level will also fall.

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