Assume that Janet Yellen (chair of the US Fed Reserve) decides to reduce the US

Question

Assume that Janet Yellen (chair of the US Fed Reserve) decides to reduce the US money supply (i.e., contractionary monetary policy) 1) Using the concept of money market equilibrium, explain what will happen to interest rates and prices in the U.S. in the short-run 2) Using the concept of interest-rate parity explain what will happen to the exchange rate of the dollar in the short-run (i.e., will it appreciate or depreciate?) 3) Given your answers to (1) and (2), do you think this policy is designed to stimulate the economy (i.e., increase production in the U.S. in the short-run)? Explain. Using the concept of money market equilibrium, explain what will happen to interest rates and prices in the U.S. in the long-ruin Using the concept of purchasing-power parity explain what will happen to the exchange rate of the dollar in the long-run (i.e., will it appreciate or depreciate?) 4) 5) 6) Given your answers to (4) and (5), do you think this policy is designed to stimulate the economy (i.e., increase production in the U.S. in the long-run)? Explain.

Explanation / Answer

1). A reduction in money supply will shift the LM curve up to the left. Thus, this will increase interest rates in the economy and increased interest rates would lead to reduced investment. Thus, crowding out of investment will eventually lead to lower level of output in the short run. When the output reduces, the price levels of the commodity will increase as the supply curve will shift to the left while the demand curve would remain at the same position.

2). A reduction in money supply, will lead to market interest rates. An increase in interest rates will attract more foreign investment in the economy. Thus, an inflow of foreign currency in the market would then appreciate the local currency.

3). This policy is basically to attract more foreign capital to the country, which would help the country raise more funding and at the same time take advantage of more innovative management and technological techniques. Thus, this policy will help the economy to strenghthen and innovate itself.

4). In the long run, increased price levels of domestic products will reduce their demands in the foreign and domestic market, thereby shiftting the demand curve and IS curve to their left. This will bring the price level and interest rates to their original level.

5). Now, when exports reduce in the long run and investment too becomes stable, the exchange rates which went up intially will eventually fall down. However, their is a chance that the exchange rate will now be higher and much stable than the original level.

6). The policy is bound to bring stability in the economy. Both the demand for goods and even domestic currency stabilizes, thereby reducing fluctuations in the economy.

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