Answer to Question #174612 in Macroeconomics for Adal Cheema

Question

Assume that the United States is operating in a short-run equilibrium where the actual unemployment rate is higher than the natural rate.

a. If the Federal Reserve decides to close this output gap using monetary policy, what open market operation should they pursue?

 

b. Based on your answer to part (a), indicate the effect of the open market operation on each of the following

i. The nominal interest rate.

ii. The real interest rate.

 

Answer 1

Solution: 

a.). The market operations that the Federal Reserve can pursue is the expansionary monetary policy.

Expansionary monetary policy is a type of macroeconomic policy intended to increase the money supply in the market by buying securities, lowering the reserve rate, and decreasing the discount rate, in order to encourage economic growth. An expansionary monetary policy will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve to shift right so that the new equilibrium occurs at the potential GDP level.

b.i).  The expansionary monetary policy will increase the nominal interest rate due to the effects of the inflation rate. Nominal interest rate is the addition of the real interest rate plus the inflation rate.

ii). The expansionary monetary policy will decrease the real interest rate due to an increase in the money supply in the economy.