Assume the United States economy has the following: GDP is $15,600 billion up fr
ID: 1159971 • Letter: A
Question
Assume the United States economy has the following: GDP is $15,600 billion up from $13,400 billion four years ago. Unemployment is at 4.0% down from 7.7% three years ago. Inflation is at 3.7% up from 1.2% four years ago. NRU = 4.0% Target Inflation is 2.0% Explain in detail the problem the country is facing. Should the Federal Reserve adopt an easy money or tight money policy? Explain! Which policy tool should the Federal Reserve use to carry out the policy you recommended in Question 2? Detailed explanation as to why the choice is correct and how the tool works to address the problem. What could happen to make the policy you recommended in Question 2 ineffective? On this question, be sure to read the section in your text beginning on page 372. Don’t just make something up. It will take a paragraph or two to answer this question because you need to relate the specific complication to the scenario described in the question.
Explanation / Answer
Ans
The economy has recovered from recession as Gdp has risen, unemployment fallen to natural rate and inflation has risen. Given the fact that unemployment is at natural rate and gdp is rising there is only one genuine problem. It is the problem of inflation which is above target rate..The fed needs to use contractionary fiscal policy. The reason is due to contractionary policy money supply in economy will fall. This will decrease purchasing power of people. As a result they will demand less and since Aggregate demand falls prices will fall. Federal reserve should achieve this goal by conducting open market operation. In other words fed will sell securities. This will reduce money supply. Consequently interbank rate rises. As costs of loans to banks rise they will increase their own lending rates. This will decrease investment and consumption. Thus Aggregate demand will fall which will reduce prices. However if banks have excess reserves with them this policy will fail.