Determine whether the Federal Reserve would pursue contractionary monetary polic

Question

Determine whether the Federal Reserve would pursue contractionary monetary policy, expansionary monetary policy, or no change in policy in each of the following situations.

     a. Inflation is 10 percent, above its average of 3 percent in the last several years: (Click to select)No change in policyContractionary monetary policyExpansionary monetary policy.

     b. The output gap is positive: (Click to select)Contractionary monetary policyNo change in policyExpansionary monetary policy.

     c. Unemployment is at a record high: (Click to select)Contractionary monetary policyNo change in policyExpansionary monetary policy.
    
     d. The economy is experiencing full employment: (Click to select)No change in policyContractionary monetary policyExpansionary monetary policy.

     e. The economy is on the brink of deflation: (Click to select)No change in policyExpansionary monetary policyContractionary monetary policy.

     f. A new technology causes output to surge: (Click to select)Expansionary monetary policyContractionary monetary policyNo change in policy.

Explanation / Answer

a. Inflation is 10 percent, above its average of 3 percent in the last several years:

Contractionary monetary policy

Reason: At this stage, unemployment is low which is good but inflation is high which is bad. If this situation is allowed to continue, it will result in increasing the inflation rate further since the economy cannot always operate beyond its long term potential. To achieve its goal of price stability, Fed adopts a contractionary monetary policy which is thus quite apposite. It puts upward pressure on wages and prices and brings the level of inflation down.

b. The output gap is positive:

Contractionary monetary policy

Reason: Contractionary monetary policy of increasing the interest rates is usually applied when the economy is operating beyond its long term potential, that is, short term real GDP is more than the long term potential GDP.

As mentioned before, if the situation of positive output gap, where inflation is high, is allowed to continue, it will result in increasing the inflation rate further since the economy cannot always operate beyond its long term potential. To achieve its goal of price stability, Fed adopts a contractionary monetary policy which is thus quite apposite. It puts upward pressure on wages and prices and brings the level of inflation down.

c. Unemployment is at a record high:

Expansionary monetary policy

Reason: To stimulate firms to provide jobs and increase employment, the Fed needs to increase consumption spending by households and investment spendings by businesses so that they can create demand for products that will force firms t hire more workers.
    
d. The economy is experiencing full employment:

No change in policy

Reason: Since current GDP equals potential GDP, Economy achieves its long run equilibrium so there is no need to change anything.

e. The economy is on the brink of deflation:

Expansionary monetary policy

Reason: Falling price level in any economy creates apprehensions about its future potential. It might be a signal of economic slack, forthcoming recession or a depressing consumption and investment demand. The Fed needs to stimulate the shrunken economy by adopting an expansionary monetary policy. It could increase the money supply through open market operations and thus reduce the interest rate. Falling interest rate would stimulate consumption and investment demand and this would shift Aggregate Demand to the right. Real GDP along with the overall price level would increase as a result.

f. A new technology causes output to surge:

No change in policy.

Reason: Since the economy is growing, its growth path should not be disturbed.

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