Part I: The Federal Reserve Can Affect The Money Supply

Part I The Federal Reserve Can Affect The Money Supply Through Open M

Part I: The Federal Reserve can affect the money supply through open market operations, changing the reserve requirement, changing the discount rate or the amount of discount loans made to banks, or by changing the interest rate on reserves. A. Assume the economy is in a recessionary gap. Draw a graph showing a recessionary gap. Draw a second graph showing money supply and money demand.

Design a monetary policy to close the recessionary gap. Verbally describe how your monetary policy works and draw the effects of your monetary policy change on your first and second graph. B. Explain the concept of money neutrality. Draw two graphs, one AD/AS and one Money Demand/Money Supply. Illustrate money neutrality on your graphs.

Paper For Above instruction

The role of the Federal Reserve in managing the economy is pivotal, especially through its ability to influence the money supply via various monetary policy tools. These tools include open market operations, reserve requirements, discount rates, and interest rates on reserves, each impacting liquidity and economic activity differently. This paper explores the effectiveness of these tools in addressing recessionary gaps, the concept of money neutrality, and demonstrates the concepts through graphical analysis.

Part A: Addressing a Recessionary Gap with Monetary Policy

In the scenario where the economy is experiencing a recessionary gap, real GDP is below the potential GDP, indicating unused resources and high unemployment. To illustrate this, a typical aggregate demand and aggregate supply (AD/AS) diagram shows the aggregate demand curve (AD) positioned to the left of the long-run aggregate supply (LRAS). This gap signifies that the economy is operating below its full employment level.

Concurrently, a money supply and money demand graph in the liquidity preference framework depicts the equilibrium interest rate and quantity of money at a lower level, reflecting reduced economic activity. A decrease in the money supply shifts the Money Supply curve leftward, increasing interest rates and decreasing investment and consumption, thus exacerbating recessionary conditions.

To close this gap, the Federal Reserve can implement an expansionary monetary policy. This typically involves purchasing government securities in open market operations, which increases the reserves of commercial banks. As reserves rise, banks are able to lend more, increasing the money supply. The increased money supply shifts the Money Supply curve rightward, lowering interest rates. Lower interest rates stimulate investment and consumption, shifting aggregate demand rightward toward the potential GDP.

This policy effect can be depicted in the graphs: in the AD/AS diagram, the aggregate demand curve shifts rightward from AD to AD', moving the economy closer to full employment and eliminating the recessionary gap. In the Money Supply/Money Demand graph, the rightward shift of the money supply lowers interest rates, encouraging borrowing, investment, and aggregate demand.

Part B: Money Neutrality and Its Graphical Illustration

Money neutrality is an economic theory stating that changes in the money supply do not affect real variables like output or employment in the long run. This concept suggests that an increase or decrease in the money supply merely affects price levels without altering real economic activity, assuming other factors remain constant.

Graphically, this is illustrated through the AD/AS and Money Demand/Money Supply diagrams. In the long run, an increase in the money supply shifts the LM curve (which represents the equilibrium in the money market) rightward, resulting in higher price levels in the AD/AS model but no change in potential output or real GDP.

In the AD/AS diagram, an increase in the money supply raises the price level from P to P', shifting the short-run aggregate supply curve upward or the aggregate demand curve rightward (if we consider the transition to the long run), but the long-run aggregate supply remains unchanged. The economy's output returns to its full employment level, affirming that monetary policy primarily influences price levels rather than real output in the long run.

Similarly, in the Money Demand/Money Supply diagram, an increase in the money supply shifts the Money Supply curve rightward, reducing interest rates temporarily, but eventually, prices adjust, and the real variables remain unaffected. The intersection point between Money Demand and Money Supply adjusts in the short run but stabilizes in the long run at the same real output level.

Conclusion

The Federal Reserve's ability to influence the economy through monetary policy is crucial in managing economic fluctuations like recessionary gaps. By expanding the money supply, the Fed can stimulate economic activity, moving the economy toward full employment. Conversely, in the long run, changes in the money supply do not affect real output, exemplifying the concept of money neutrality. These dynamics are well captured through graphical analysis, emphasizing the importance of understanding monetary policy's short-term effects and long-term neutrality.

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