ECO 201 Ch. 15 Practice (answers) PDF

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ECO 201 Ch. 15 Monetary Policy Practice Answers

1. Refer to the figure above to answer the following questions: a. If actual real GDP in 2006 occurs at point B and potential GDP occurs at LRAS06, should the Federal Reserve pursue expansionary or contractionary monetary policy? Why? b. If the Fed's policy is successful, what is the effect of the policy on actual real GDP, potential real GDP, the price level, and unemployment? c. What specific policies would achieve the Fed’s goal? Answers and comments: The short-run equilibrium at Point B is to the right of the LRAS curve, resulting in inflation. The economy is growing, but at a pace that is fast enough to cause too much inflation. Since inflation is the problem the Fed would be addressing, contractionary monetary policy would be appropriate. As the policy takes effect, the equilibrium point would move to point C (AD shifts to the left), causing the following: • • • •

Actual real GDP decreases Potential real GDP does not change Price level decreases Unemployment increases

Since the Fed will be pursuing contractionary policy, these actions would be appropriate: 1. Sell Treasury securities (open market operations) 2. Increase the discount rate 3. Increase the reserve requirement (Note: If the above situation was a recession and the Fed pursued expansionary policy, everything would be opposite of the underlined answers above – with the exception of what happens to potential GDP. It does not change in the short run.)

2. a. Consider the table above. What policy actions can we expect from the Federal Reserve as it seeks to move the economy in the direction of long-term equilibrium? b. If the Fed’s policy is successful, what would happen to the following indicators? • Actual real GDP • Potential real GDP • Price level • Unemployment Answers and comments: This problem is similar to Question 1. The difference is in how the information is given in the problem; we are looking at equilibrium on a table instead of a graph. In 2013, real GDP is higher than potential, resulting in inflation. The policy answer and results are the same as Question 1 above.

3. Does the graph above illustrate expansionary or contractionary monetary policy? How do you know? Assume Points A and B happen in chronological order. Answer and comments: If short-run equilibrium moves from Point A to Point B, we can assume the Fed pursued expansionary policy. Point A, because it is to the left of the LRAS curve, represents a recession. Appropriate monetary policy for a recession would be expansionary, with the goal of moving the economy to a point on the LRAS curve or Point B. As the economy moves to Point B, we see the following: • • • •

Actual real GDP increases Potential real GDP does not change Price level increases Unemployment decreases

4. Can the Fed eliminate recessions? Explain. Answer and comments: The Fed cannot eliminate recessions. Recessions are a normal part of the short-run business cycle. Monetary policy can make a recession less severe and can possibly speed up a recovery, depending on the causes and magnitude of the recession (and, to a certain extent, what Congress is doing with fiscal policy).

5. Refer to the graph above and answer the following: a. If the Fed takes no policy action, what would the inflation rate be in 2021? b. If the Fed pursues appropriate monetary policy, what would the inflation rate be in 2021? Answers and comments: With no policy action, we can assume the economy will land at the short-run equilibrium to the right of the 2021 LRAS curve. Use the formula for calculating the inflation rate that you learned from Chapter 9, substituting the GDP price deflator shown on the graph for the CPI: Inflation rate = (GDP deflator 2021 – GDP deflator 2020)/GDP deflator 2020 x 100 = (124 – 120)/120 = 3.3% If the Fed intervenes, they would choose a contractionary policy. This would move the AD curve to the left and the new equilibrium would be on the 2021 LRAS curve. With policy, the inflation rate would be: Inflation rate after policy = (122 – 120)/120 x 100 = 1.7% The effect of the contractionary policy is to reduce inflation – exactly the result we would want....