Question

a. Suppose the economy is in an inflationary gap. If the correct monetary policy is used how will the Federal Reserve wish to change its interest rate target?

b. Explain how the Fed, using open market operations, would do that.

c. Then show, using the liquidity preference model(chapter 15), show how equilibrium interest rates and the money supply change(draw a graph).

Answer 1

a) if the economy is in an inflationary gap the Federal Reserve would use the contractionary monetary policy. This will lead to a decrease in the money supply. So, the Federal Reserve would wish to increase its interest rate target such that the inflationary gap in the economy could vanish.

b) FED would conduct the open market Sales of the treasury securities. This woul lead to a Decrease in the money supply in the Economy and is a tool of Contractionary Monetary Policy.

c) money supply would decrease and the equilibrium interest rates would increase as shown in the graph below.