Macroeconomics

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Suppose the Fed wishes to use monetary policy to close an expansionary gap.

a. Should the Fed increase or decrease the money supply?

b. If the Fed uses open-market operations, should it buy or sell government securities?

c. Determine whether each of the following increases, decreases, or remains unchanged in the short run: the market interest rate, the quantity of money demanded, investment spending, aggregate demand, potential output, the price level, and equilibrium real GDP.


These questions can largely be answered by the basic formula MV=PQ, where M=money supply, V=velocity, and P=general price level, Q=general output level. PQ is GNP or total expenditures. An expansionary gap, aka an inflationary gap occurs when total spending is greater than what is needed to have full employment without inflation.

a) Given a constant V, lowering M, lowers total spending.

b) When the Fed buys securities, it is putting money into the economy in exchange for government debt.

c) draw a supply and demand curve for money. On the y-axis is the interest rate, x-axis Money. Reducing M shifts the supply curve inward. What happens to the equilibrium interest rate? (hint: increases) Quantity of money demanded is movement along the demand curve. What happens to the equilibrium level of money? With the increase in interest rates, will people invest more or less? Investment spending is a component of aggregate demand (GNP=C+I+G) So, what happens to total aggregate demand with your change in investment spending?

Take a shot on the remaining. Potential output is the amount that would be produced at full employment -- in real terms, measured without inflation.


Suppose the Fed wishes to use monetary policy to close an expansionary gap.


Determine whether each of the following increases, decreases, or remains unchanged in the short run: the market interest rate, the quantity of money demanded, investment spending, aggregate demand, potential output, the price level, and equilibrium real GDP.


market interest rate- increases

quantity of money demanded- unchanged

investment spending- decrease

aggregate demand- increase

potential output- increase

price level- increase

equilibrium real GDP- decrease


market interest rate increases CORRECT.

quantity of money demanded, I think DECREASES. Here is problem of semantics -- terminology that describes things. We generally say that a change in demand is a shift in the demand curve. This clearly does not change in your example problem. However, a change in quantity demanded is a movement along the demand curve. Except in some extreme elasticity assumptions, the quantity demanded is less under your problem.

Investment spending decrease CORRECT.

Aggregate demand increase INCORRECT. Aggregate demand = Aggregate spending = C+I+G. If I goes down, aggregate demand goes down.

Potential output- increase. INCORRECT.
I would argue that potential output does not change. Potential output is the output, in real dollars, that could be obtained under full employment. (One could argue that with less investment there would be less capital and potential output goes DOWN. However, I would argue that potential output includes full use of capital).

Price level- increase. INCORRECT. The goal of closing an expansionary gap is to lower inflation pressure. Price level should decline. (More precisely, price levels should be less than they otherwise would have been).

equilibrium real GDP- decrease. CORRECT -- because of a decline in investment.

  • Macroeconomics -

    List and explain the three tools used by the Fed to manipulate the supply of money. In each case show how the money supply can increase/decrease.

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