3. The Federal Reserve Board has 3 basic tools, while the federal government has
ID: 1097506 • Letter: 3
Question
3. The Federal Reserve Board has 3 basic tools, while the federal government has 2 tools to help to stabilize the economy. If the Fed and government thought that the economy were growing too slowly or showing signs of higher than desired inflation, they would act in concert. a) If there are signs of weakening demand, would the Fed buy securities from or sell securities to banks and businesses. b) Briefly explain how those actions would impact the economy in terms of money supply, commercial bank reserves, interest rates, components of Aggregate Expenditures, GDP, employment and incomes in the short-run. This is the spiral. c) What are some fiscal steps that the government could take in order to lessen the impact of recession? d) Why are federal deficits a concern for the larger economy in the long term?Explanation / Answer
a)
The Fed would want to tackle weakening demand by buying securities from the banks and businesses. This would lead to an increase in money holdings of the banks and businesses and hence an increase in the overall economic activity. Aggregate demand would thus rise.
b)
The 3 tools with Fed are as follows:
The three tools mentioned impact the money supply in the economy. An increase or decrease in the money supply causes a change in the consumer spending and thus affects the aggregate demand curve of the economy. The changes in the monetary policy do not shift the aggregate supply curve. It just causes a movement along the curve.
Thus, in the short run aggregate demand rises if money supply rises, interest rates fall and employment rises.
c)
When the government uses fiscal policy to stimulate aggregate demand during a recession, it is called an expansionary fiscal policy.
Under the expansionary fiscal policy government either increases its expenditure or reduces taxed to stimulate aggregate demand in the economy.
d)
The interest payments on this portion of the debt must be made to those outside the country. That means that the country must earn enough income from exports and other sources to pay not only for imports but also for interest payments to the rest of the world. Alternatively, the country could borrow more, but it is best to avoid this solution, since it would just make the overall foreign debt problem larger in the long run
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