Question

1. Using the monetary policy tool the Fed employs most often, the Fed closes an inflationary gap. Describe the steps the economy goes through to move to the new equilibrium output and price level. Use graphs with your answer and be sure to label everything completely.

2.Explain and show on a graph the short-run and long-run equilibrium changes in the AD/AS model from expansionary monetary policy. How does this support an anti-monetary policy stance?

3. What is the equation of exchange? Explain.

Answer 1

(1)

An inflationary gap exists when aggregate demand is so high than real GDP exceeds potential GDP, leading to high inflation. Fed can close the inflationary gap with contractionary monetary policy by decreasing money supply by open market sale of federal securities. When money supply decreases, interest rate increases which decreases investment and decreases the portion of consumption demand funded by borrowing. As a result, aggregate demand falls, shifting AD curve leftward, lowering price level and real GDP.

In following graph, during inflationary period, the economy is at point B where aggregate demand (AD1) intersects short-run aggregate supply curve (SRAS0) to the right of long-run aggregate supply curve (LRAS0) with price level P1 and real GDP Y1, creating an inflationary gap equal to (Y1 - Y0). When Fed lowers money supply, aggregate demand falls, shifting AD1 leftward to AD0 where it intersects SRAS0 and LRAS0 at point A with lower price level P0 and restoring real GDP to potential GDP of Y0, eliminating inflationary gap.

NOTE: As per Answering Policy, 1st question is answered.