Question

Suppose that a fall in house prices decreases wealth substantially. (For simplicity, assume that the economy begins in long-run equilibrium.)

a. How will this change affect output in the short run?

b. Suppose the Federal Reserve wants to prevent the impact you found in part (a). Should it increase the real interest rate, decrease it, or leave it unchanged (or is it not possible to tell)?

c. How, if at all, should the Federal Reserve change the supply of money in order to bring about this change in the real interest rate?

Answer 1

a) A decrease in the wealth of the people will reduce their consumption of goods and services in the economy. From the point of long-run equilibrium, the aggregate demand curve will shift to the left i.e. there will be a decrease in the output and fall in the price of goods and the unemployment will increase.

b) With a decreased aggregate demand in the economy, the federal reserve will decrease the interest rates in the economy. At a lower rate, the investment will increase and the demand will come back to the equilibrium.

c) The Federal Reserve would increase Open market operation and they will buy the bonds form the market. Or the Federal Reserve could reduce the Reserve rates or decrease the discount rates. All these steps will increase the money supply and reduce the interest rates.