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You are the Chairperson of the Federal Reserve, the date is June 2008 and a recession is ahead. Using the monetary tool(s) of your choice what would you do? You need to graph a money demand and supply graph, an Investment graph, and a GDP graph to show how monetary policy effects GDP. You also need to use the money multiplier, MPC and the GDP multiplier on the GDP graph.
Answer :- Recession is a slowdown or a massive contraction in economic activities. A significant fall in spending generally leads to a recession. Hence, Federal reserve will use Monetary tools to increase the GDP of the country. Federal reserve will follow following steps to increase the GDP. 1) Money supply and Money demand The demand curve for money illustrates the quantity of money demanded at a given interest rate. Notice that the demand curve for money is downward sloping, which means that people want to hold less of their wealth in the form of money the higher that interest rates on bonds and other alternative investments are. The central bank controls the supply of money, and they interact with other financial institutions. This interaction is part of the money market, and we can illustrate it using a supply curve. The supply curve for money illustrates the quantity of money supplied at a given interest rate, and here’s what that looks like. Notice that unlike a typical supply curve in the product market, the supply curve for money is vertical, because it does not depend on interest rates. It depends entirely on decisions made by the central bank. Firstly , Fed will increase the money supply (explained in the last) . This will shift the vertical money supply curve rightwards as shown :- As shown, This will result in decrease in interest rate. 2) Investment schedule Investment Schedule shows that the amounts firms plans to invest at various possible values of real…

ross domestic product it. Investment schedule is downward sloping because real interest rate helps to determine the trend of investment in an economy. When the interest rates are high, borrowing becomes quite expensive for the investors so they make less real investment. The high interest rates make it difficult to cover their expenditure because their products becomes less competitive in both the domestic and international market. Hence when interest rate falls , Investment spending increases. 3) AD and AS curve Aggregate supply is thetotal value of the goods and services produced in a country, plus the value of imported goods less the value of exports. This curve is upwards sloping Aggregate demand is the sum of all demand in an economy. This can be computed by adding the expenditure on consumer goods and services, investment, and not exports (total exports minus total imports). This curve is downwards sloping. As, Y = C + I + G + NX Hence, Increase in investment spending will shift the AD curve rightwards as shown :- As shown , Real GDP increases from Ye to Yf. Hence, to cope up with recession , Fed will increase the money supply in the country.Because money is used in virtually all economic transactions, it has a powerful effect on economic activity. An increase in the supply of money works both through lowering interest rates, which spurs investment, and through putting more money in the hands of consumers, making them feel wealthier, and thus stimulating spending. Business firms respond to increased sales by ordering more raw materials and increasing production. The spread of business activity increases the demand for labor and raises the demand for capital goods. In a buoyant economy, stock market prices rise and firms issue equity and debt. If the money supply continues to expand, prices begin to rise, especially if output growth reaches capacity limits. As the public begins to expect inflation, lenders insist on higher interest rates to offset an expected decline in purchasing power over the life of their loans. Hence, in situation like recession , where the GDP is falling , in order to spur GDP , Fed have to increase the money supply.



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