Suppose that the Fed has decided that it should have an activist monetary policy

Question

Suppose that the Fed has decided that it should have an activist monetary policy in order to stabilize the level of GDP by managing the money supply. When the following events occur, show whether the Fed’s policy will actually stabilize GDP or not:

a)     An increase in aggregate demand in the economy leads to an increase in the demand for money.

b)     People increasingly distrust the banking system and decide to hold a higher proportion of their money in their pockets.

c)     During a serious recession, the demand for money falls.

d)     Bank managers become more aggressive, and decide that they can operate with fewer excess reserves.

Explanation / Answer

a) An increase in aggregate demand in the economy which leads to an increase in demand for money can be tackled by the monetary policy tools.This would require a contractionary monetary policy whereby a reduction in money supply would increase the interest rate in the economy.An increase in interest rates would lead to a reduction in investment spending , thus leading to a fall in aggregate demand.

b)If people stop trusting the banking system and deposit lesser and lesser money in banks , the monetary policy would be ineffective in such a scenario.Central bank via monetary policy tends to control the amount of money supply in the economy and thus regulate the aggregate demand in the economy.If people stop trusting banks and use it for lesser number of times , that would render the monetary policy of central bank ineffective as lesser amount would now flow through banks.

c)In order to overcome a situation of recession central bank can use expansionary monetary policy.An expansionary monetary policy would lead to an increase in aggregate demand in the economy and thus overcome the recessionary situation.

d) In case the bank managers decide to hold a fewer amount of excess reserves ,This emplies it would have a fewer amount to lend to its consumers.Thus fewer excess reserves would translate into fewer number of loans in the society.Fewer bank loans decreases the central bank's control over the money supply in the economy and thus reduce the effectiveness of monetary policy.

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