Question

During the late 70s and early 80s, the U.S. economy faced an inflationary period. The chairman of the Fed at that time, Paul Vocker, pursued a monetary policy to reduce inflation in the long run. The principal method used by the Federal Reserve to change the money supply is through open market operations.

1. Which policy would accomplish the Fed's goal to reduce inflation (buy or sell bonds) in the long run?

2. Use the Quantity Theory and Fisher Equation to explain what happens to the economy in the long run, particularly to: (i) prices and nominal output; (ii) real in GDP; (iii) inflation and nominal interest rate; (iv) money demand; (v) real interest rate

Answer 1

(a) In order to reduce inflation, the Fed will have to reduce the amount of money in the economy. This will happen if it sells the bonds as people purchase and pay for it which takes the money out of the banking system.

(b) Quantity theory of Money: MV = PY

Fisher equation: real interest rate = nominal interest rate - inflation

In the long run, an increase or decrease in the money supply does not lead to changes in any real variables and only inflation increases one for one.

Thus, as a result of monetary contraction, prices will fall and nominal output = pricest*output will also fall. Since the output remains the same, the Real GDP will not change. As the prices are falling inflation will also fall and the nominal interest rates will rise. The money demand is not affected by changes in the money supply. The real interest rates will also fall (from fisher equation).