Question

1. Draw an AD/AS graph to demonstrate an economy that has come to rest in an inflationary gap. Label this equilibrium point 0.
2. Describe how the Federal Reserve Bank could use open market operations (buy or sell treasury bonds) to cool the economy and describe the effect this has on bank T accounts.
3. Show the effect of this policy on the AD/AS graph and explain what shifts, and why.

Answer 1

Figure a) shows the economy with an inflationary gap. Y* is the full potential level of output and Y1 is the actual output. The distance between potential and actual output is called Inflationary Gap.

In order to reduce the inflationary gap, there is a need to adopt a Contractionary Monetary Policy. Fed has to make an open market operation of selling the treasury bonds in the market. This would reduce the supply of money and also the purchasing power of the consumer. The stocks of treasury bonds with the Fed decrease and there will be higher supply of bonds in the bonds in the market. People will start spending less on goods and services. As a result, the AD curve shifts left from AD1 to AD2. Economy is again back to full employment equilibrium. The price level reduces from P1 to P2. Refer to figure b)