Question

Consider the current situation with the coronavirus outbreak. a. What do you think is the overall effect on the economy? (Hint: what are we afraid of happening to the economy?)

b. What should the Fed do (as it has done) in this situation? Describe the type of monetary policy, the steps the Fed takes, and the consequences (linking each factor to the next).

c. Graph the money market before and after the change. Make sure you: label the axes, the money supply and demand curves, and original equilibrium interest rate. Then show what shifts, and what happens to the interest rate.

d. Suppose that the Federal Reserve requires a reserve ratio of 0.2. How much is the money multiplier (with one decimal)?

e. In order to increase the quantity of money in the economy by $150 billion, would the Fed buy or sell bonds, and what amount?

Answer 1

(a)

The corona scare has resulted in decrease in both consumer confidence and investor confidence, which has decreased aggregate demand.

(b)

Fed should use expansionary monetary policy by

(I) open market purchase of bonds,

(II) decreasing reserve ratio or

(III) decreasing discount rate, to increase money supply and decrease interest rate.

Lower interest rate will increase investment demand, thus increasing aggregate demand.

(c)

This increase in money supply will shift money supply curve rightward, decreasing interest rate and increasing quantity of money.

In following graph, In each graph, MD0 and MS0 are initial money demand and supply curves, intersecting at point A with initial interest rate r0 and quantity of money M0. When money supply rises, MS0 shifts right to MS1 and intersects MD0 at point B with lower interest rate r1 and higher quantity of money M1.

(d)

Money multiplier (MM) = 1 / Reserve ratio = 1 / 0.2 = 5.0

(e)

To increase quantity of money, Fed has to buy bonds worth ($150 billion / 5) = $30 billion.

This will shift AD curve leftward, decreasing both price level and real GDP in short run, causing a recessionary gap.