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.
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.
a. To close an expansionary gap, the Fed should decrease the money supply. This is because reducing the money supply would lower total spending, helping to bring it closer to the level needed for full employment without inflation.
b. If the Fed uses open-market operations, it should sell government securities. When the Fed sells securities, it takes money out of the economy in exchange for government debt. This helps to reduce the money supply and decrease total spending.
c. In the short run, the market interest rate would increase. The decrease in the money supply would cause the demand for money to exceed the available supply, leading to an increase in the interest rate.
The quantity of money demanded would remain unchanged because it is determined by factors such as income, wealth, and interest rates, which are not impacted by the change in the money supply.
Investment spending would decrease. This is because higher interest rates would make borrowing more expensive, discouraging businesses from taking on new investments.
Aggregate demand would decrease. Since investment spending is a component of aggregate demand, a decrease in investment spending would lead to a decrease in overall aggregate demand.
Potential output would remain unchanged. Potential output represents the level of output that can be achieved at full employment, and it is not directly affected by changes in monetary policy.
The price level would decrease. The goal of closing an expansionary gap is to reduce inflationary pressures. By reducing aggregate demand, the decrease in spending would lead to a decrease in the overall price level.
Equilibrium real GDP would decrease. With a decrease in aggregate demand, the economy would experience a decrease in real GDP in the short run.
a. The Fed should decrease the money supply.
b. If the Fed uses open-market operations, it should sell government securities.
c. In the short run:
- The market interest rate increases.
- The quantity of money demanded decreases.
- Investment spending decreases.
- Aggregate demand decreases.
- Potential output remains unchanged.
- The price level decreases.
- Equilibrium real GDP decreases.