Suppose that the chairman of the Federal Reserve Board decides to intervene in t

Question

Suppose that the chairman of the Federal Reserve Board decides to intervene in the economy at the Federal Open Market Committee Meeting, increasing short term interest rates

) Now state in words the impact in the economy in the short run. In particular, explain what will happen in the goods markets and in the money markets. What are the final effects of this policy on prices and output in the short run? Explain what the monetary mechanism is in this context.

(d) Use the IS-LM diagrams to graphically illustrate the impact of a Federal Reserve decision in the long run.   Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift, v. the long-run equilibrium values.

(e) Now state in words the impact in the economy in the long run. What is the key variable that links the short run to the long run, and how in this case? What are the final effects of this policy on prices and output in the long run? Explain what the Classical dichotomy is in this context.

(f)    Draw a graph showing the effect of this policy on real GDP over time, that is, a graph showing the economic fluctuation in the short run and in the long run (GDP real in the Y-axis and time in the X-axis).

Explanation / Answer

Buying securities in open market will increase the money supply in the economy, thereby reducing interest rates. The reduction in interest rate will stimulate investment in the economy, thus increasing GDP in the economy. Aggregate supply will shift right thus increasing the output and decreasing the prices.

In the long run, increase in money supply in the economy will put upward pressure on domestic currency. This in turn will reduce the net exports which in turn will balance the increase in output.

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