8. Suppose the following table illustrates the values of actual and potential Re

Question

8. Suppose the following table illustrates the values of actual and potential Real GDP, and the price level if the Fed does not vote to change their current policy to be more contractionary or expansionary.

Year                   Potential Real GDP         Actual Real GDP              Price level   Inflation

                                      Y*                                       Y                                P                  

2000                      $12.0 trillion                     $12.0 trillion                       110              2%

2001                      $13.0 trillion                     $12.8 trillion                       104              1%

a. What problem occurs in the economy in year 2001? What type of recession or economic expansion is present? Illustrate the state of the economy in year 2001 graphically.

b. Given the state of the economy in 2001, assuming the natural unemployment rate of 5%, find the output gap in percentage points and the actual unemployment rate. What type of unemployment is present?

c. If the Fed wants to keep actual Real GDP in 2001 at its potential level, what type of monetary policy should the Fed use? What would be the goal of monetary policy?

d. Should the Fed raise or lower the target for the federal funds rate?

e. Use the Taylor rule and find the new target for the FFR in 2001 given the output gap and actual inflation in year 2001

f. Should the Fed purchase or sell government bonds to meet the new target for the federal funds rate?

g. Use the supply and demand for bonds concept, explain and illustrate the effect of the Fed action on:

- Supply or demand for bonds

- Bonds prices

- Interest rates associated with these bonds

h. Use the money market diagram to explain and show graphically the Fed open market operations effect on:

- The money supply in the economy

- The short-term interest nominal interest rate.

- Explain what will happen to the real interest rates

i. Use the basic AD-AS diagram to explain verbally and illustrate graphically how the monetary policy chosen by the Fed moves the economy to the full employment level of Real GDP

k. What would be the benefit, the cost of moving the economy to the potential Real GDP? Use the short-run Phillips Curve to illustrate the cost

Explanation / Answer

The economy suffers from the negative output gap. A negative output gap occurs when actual output is less than what an economy could produce at full capacity. A negative gap means that there is spare capacity, or slack, in the economy due to weak demand.­ When the output gap is negative over time, so that actual output is lesser than potential output, prices will begin to fall in response to demand pressure in key markets.­ Typically during a recession, actual economic output drops below its potential, which creates a negative output gap. That below-potential performance may spur a central bank to adopt a monetary policy designed to stimulate economic growth—by lowering interest rates, for example, to boost demand and prevent inflation from falling below the central bank’s inflation rate target.­

Accordig to Okun’s law,

(y – y*)/y* = -c(u-u*)/u*

Here we know u* = NAIRU = 0.05 and y and y*, based on the value of c wecan calculate u.

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