Question

Week 4 Assignment                                                                                                  10 Points

a) What are the three functions money should be able to perform in our economy? (Minimum 50 words)

b) Explain the three main ways the Federal Reserve can change the money supply in the economy? (Minimum 100 words)

c) If the Federal Reserve is following a restrictive monetary policy by lowering the money supply in the economy, what will be its effect on the equilibrium outcome in the economy as it relates to real GDP and the price level? Explain using AS-AD analysis. (Minimum 100 words)

Answer 1

a. Functions of money include:

i. Money is used as a medium of exchange. We can buy the commodities against the value of money.

ii. Money can store value. Thus, we can save using money.

iii. Money can be used as a means of deffered payments. For instance, through credit cards, we can buy now and pay later.

b. The Fed uses the following ways to change the money supply in the economy:

i. Change in interst rates: The central bank can change the bank rate, reserve repo rate etc. in order to influence the money supply.

ii. Open market operations: The central bank buys and sells the government securities to influence the money supply.

iii. Change in CRR: The Fed can change the cash reserve ratio to influence the money supply.

C. If the fed follows a restrictive monetary policy, it implies that the money supply will reduce in the economy. This will impact the aggregate demand in the economy. The aggregate demand curve will shift to the left due to the monetary policy.

Thus, the new aggregate demand curve will intersect the old aggregate supply curve at lesser equilibrium level of income and higher price level.