The hypothetical information in the following table shows what the situation wil
ID: 1157568 • Letter: T
Question
The hypothetical information in the following table shows what the situation will be in 2017 if the Fed does not use monetary policy. (35 points)
Year Potential GDP Real GDP Price Level
2016 $18.7 trillion $18.7 trillion 116.2
2017 19.1 trillion 19.3 trillion 120.0
a) If the Fed wants to keep real GDP at its potential level in 2017, should it use an expansionary policy or a contractionary policy? Should the trading desk be buying T-bills or selling them?
b) If the Fed’s policy is successful in keeping real GDP at its potential level in 2017, state whether each of the following will be higher, lower, or the same as it would have been if the Fed had taken no action:
1) Real GDP;
2)Potential GDP;
3)The inflation rate;
4)The unemployment rate.
c) Draw an aggregate demand and aggregate supply graph to illustrate the effects of the Fed’s policy. Be sure that your graph contains LRAS curves for 2016 and 2017; SRAS curves for 2016 and 2017; AD curves for 2016 and 2017, with and without monetary policy action; and equilibrium real GDP and the price level in 2017, with and without policy.
Explanation / Answer
a) Since we want a lesser GDP, it should adopt a contractionary policy. A contractionary policy would decrease the money supply in the market which means that the GDP or nominal output would decrease. This would mean that Fed should be selling T-bills to decrease money in the market.
b) 1)Lower
2)Same : As our aim was to set such a monetary policy that equals the potential GDP
3) Inflation rate should be low as money supply in the market has decreased. This means that people would demand a lesser amount of goods which would decrease inflation.
4) Since inflation is lesser, due to the Phillips curve, unemployment would be higher.
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