Assume that Janet Yellen (chair of the US Fed Reserve) decides to reduce the US
ID: 1119157 • Letter: A
Question
Assume that Janet Yellen (chair of the US Fed Reserve) decides to reduce the US money supply (i.e., contractionary monetary policy) 1) Using the concept of money market equilibrium, explain what will happen to interest rates and prices in the U.S. in the short-run 2) Using the concept of interest-rate parity explain what will happen to the exchange rate of the dollar in the short-run (i.e., will it appreciate or depreciate?) 3) Given your answers to (1) and (2), do you think this policy is designed to stimulate the economy (i.e., increase production in the U.S. in the short-run)? Explain. Using the concept of money market equilibrium, explain what will happen to interest rates and prices in the U.S. in the long-ruin Using the concept of purchasing-power parity explain what will happen to the exchange rate of the dollar in the long-run (i.e., will it appreciate or depreciate?) 4) 5) 6) Given your answers to (4) and (5), do you think this policy is designed to stimulate the economy (i.e., increase production in the U.S. in the long-run)? Explain.Explanation / Answer
A contractionary monetary policy refers to decrease of money supply, via open market operation.
(1) Money market is in equilibrium when, the negatively sloped money demand curve intersects the vertical money supply curve, with interest rate on y-axis, while amount of money in x-axis. If money supply is decreased, then it will intersect the money demand curve at higher interest rate and lower amount of money. Also, it will reduce the aggregate demand, and hence, price will decrease. Hence, in the short run, interest rate will increase, while price will decrease.
(2) According to the concept of interest rate parity, the interest rate between countries is same, after accounting for the spot exchange rate. If interest rate in home nation is increased, there will be a capital inflow in the home nation, and since, it will afect the money supply by increasing it, and hence, interest rate will be reduced to the parity condition. So, in this case, interest rate will be reduced, and money supply and price level will be restored to prior level.
(3) The policy itself, even after removing the interest rate parity, is NOT designed to stimulate the economy, but to decrease the price level (ie inflation). Incorporating both cases, the policy is designed to inflow of foreign currency, and hence to appreciate the currency in case of fixed exchange rate (sterilization). In case of flexible exchange rate, also induces the aggregate demand to decrease. Hence, policy is not designed to stimulate the economy.
(4) In the long run, the aggregate supply curve would be vertical, and constant as the expectations of price level will be equal to actual price level. A reduction in money supply, and hence an increase in interest rate would decrease the daggregate deman, and hence the output decrease, but not for a long period. In the long run, and as price stickiness exists and expectations about prices are adjusted, the aggregate demand will increase and hence economy will return to the previous output level, but at a lower price, and restored interest rate. Hence, in the long run, after expectation adjust, the price will decrease, and the money demand is increased, inducing the same interest rate as before, but with a lower money supply.
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