Question

Question 16 5 pts Assuming that the Fed wants to keep the price level constant, what must it do to achieve a long-run equilibrium in the real money market? 12ptv Paragraph BI U ALTUB

Answer 1

To fundamentally understand the operational mechanism of the monetary policy by Fed, it would be helpful to focus on the money equation which states that M*V=P*Y or M*V/Y=P where M,V, P, and Y represent the money supply, velocity of money, the overall price level of goods and services, and the aggregate output or nominal GDP in the economy. Now, based on the money equation, note that if the Fed changes the money supply M the money velocity V and/or the aggregate output level Y have to adjust accordingly to keep the price level of goods and services at its initial or original position. For example, considering a recessionary phase in the economy, if Fed intends to increase M or money supply then the money supply curve in the money or loanable funds market would shift to the right thereby causing a decrease in the interest rate and inducing aggregate investment expenditure by firms or companies and aggregate consumption expenditure on goods and services by individuals and households, holding everything else constant and especially the money demand in the market. Now, based on the money equation, if there is no change in V and/or Y, an increase in M would lead to a consequent increase in P or implying an inflationary effect or impact in the economy. Hence, in this case, the Fed has to ensure that either V has to decrease proportionately or Y has to increase in the equivalent proportion to keep P constant at its erstwhile level. If there is any change in either V or Y following the expansion in M, then again one of them(V or Y) has to adjust accordingly to compensate for the change in the other to keep the P unchanged or stable.

Similarly, during economic expansion or growth, if Fed intends to undertake or implement a contractionary monetary policy by reducing the money supply or M in the economy, it would eventually cause a leftward shift of the money supply curve thereby increase the interest rate in the money or loanable funds market. This would essentially reduce or decrease the aggregate investment expenditure by firms or companies and aggregate consumption expenditure by individuals and households on goods and services as well. Now, in this case, in order to keep the P stable or constant, the Fed somehow has to ascertain that the money velocity V increases proportionately or nominal GDP Y decreases commensurately to avoid any downward pressure on the price level of goods and services in the economy or P thereby causing a deflationary effect or impact in the economy. In this regard, if there is any individual change in V or Y following any change in M by the Fed, then either one(V or Y) would have to adjust to adjust or compensate for the change in the other to ensure the constancy of P. Therefore, a separate and /or simultaneous adjustments in both V and Y are required to support any monetary policy by Fed with the inherent motive to keep the price level of goods and services or P constant in the economy.

Hence, based on the possible impact of the Fed's monetary policy on P with reference to the money equation, the Fed has to be carefully observant about the prevailing V and Y in the economy as well as the monetary policy is the main policy tool that it can use to establish long-term equilibrium in the market or loanable funds market. Therefore, for example, if the V is excessively high, then holding Y constant, the Fed can proportionately reduce the M or if Y is too high, then again keeping V constant, the Fed can increase M and vise versa to achieve the desired P in the economy. However, it is also important to note that such adjustments or changes in the monetary policy by the Fed to stabilize the P has to be in conjunction with the long-run money market equilibrium, in this particular instance.