Assuming that the Fed judges inflation to be the most significant problem in the
ID: 1209434 • Letter: A
Question
Assuming that the Fed judges inflation to be the most significant problem in the economy and that it wishes to employ all of its policy instruments except interest on reserves, explain how the Fed should implement its three policy tools to contain inflation. In your essay, focus on the following questions: What are the different policy tools the Fed uses to address significant economic problems? What problems can inflation cause in an economy? Which policy tool or combination of policy tools would work best to contain inflation? Does the policy tool or combination of policy tools differ in case of low inflation?Explanation / Answer
In economy money serve three purposes, medium of exchange, store of value, and unit of account. Like all other commodity money also has its own price. The price of money is the opportunity cost of holding money in cash.
The inflation is the sustained increase in general level of prices during a given period of time. The inflation redistributes the real income of the citizen by increasing or decreasing price of the basket of goods they consumes. Inflation lowers the purchasing power of money. A fixed bundle of goods and services demand more money if there is inflation.
The Fed in order to correct any imbalances in the economy changes the money supply to influence aggregate demand. The Federal Reserve Board of Governors and the FOMC are the prime decision maker for U.S. monetary policy. They decide whether to expand money supply to increase economic activity or to decrease money supply to decrease inflation. The Fed has three major methods by which to control the supply of money: it can engage in open market operation, change reserve requirement, or change its discount rate.
An inflationary gap is the condition in which the Real GDP that the economy is producing is greater than the Natural Real GDP and the unemployment rate is less than the natural unemployment rate. In inflationary gap the short run equilibrium real GDP is greater than the natural real GDP.
To combat or off set the inflationary gap the economy needs to produce less than what it is producing in the short run. Thus it needs to decrease its aggregate expenditure and real GDP. Hence the Fed to a contractionary monetary policy to stabilize the economy.
The Phillips curve gives the inverse relationship between inflation and unemployment in the short run. This curve is based on the expectations of individual about the inflation rate based on the current policy actions. In the short run the equilibrium in the economy occurs where the aggregate demand equals aggregate supply. Any change in the aggregate demand or the supply changes the price level in the economy and hence inflation.