PROBLEM SET Monetary policy

1. What impact will an unanticipated increase in the money supply have on the real interest rate, real output, and employment in the short run? How will expansionary monetary policy affect these factors in the long run? Explain.

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The money supply in an economy is the benchmark by which interest rates are determined. The supply of money is directly tied into the amount of money that can be loaned and borrowed in various capacities. The more money there is to loan, the less “expensive” it is to borrow that money. This is because when there is an increase in the money supply, the demand for that money fluctuates as well. This causes an increase in the overall amount of money being exchanged, and in turn, also causes a decrease in the real interest rate. The decrease in the interest rate also affects the economic appeal of domestically produced goods and services. This causes increased economic activity and the increase of real output because of that activity. When output increases, economic theory says that employers will typically need to hire more workers in order to handle their increased sales and output. However, this may not be the case in todays modern economy because modern businesses’ potential output are not directly proportional to their workforce. The long run economic impact depends on whether or not the unexpected short run money supply increase is permanent or not. If the money supply increase is permanent, then the short run effects mentioned above will drive the output of the economy above where it naturally should be. If the Fed decided to implement an Expansionary monetary policy to counteract this increase in the money supply then it would most likely try to reduce interest rates. This type of monetary stimulus affects the interest rates in the short term. This can eventually lead to long term economic change based on short term economic change being as the Fed intended. Expansionary policies are meant to push the economy towards full employment and spur economic growth. This means that if the policy is not closely monitored, or not removed at the right time, it can cause inflation, and thereby increase interest rates in the long run.

2. How rapidly has the money supply (M1) grown during the past twelve months? State the rate of growth (use and the most recent release, use the seasonally adjusted figures. Calculate the rate of growth across the year by taking the (new amount of M1- old amount of M1)/old amount of M1). Given the state of the economy, should monetary authorities increase or decrease the growth rate of money? Explain why.

The M1 money supply grew by a rate of 8.86%. This is based on the Jan 2014 M1 supply number of 2,683.0 billion, and Jan 2013 number of 2,464.5 billion. This indicates a healthy growth rate of the economy and the M1 money supply. According to the reports issued by the board of governors of the Federal Reserve, Unemployment is decreasing, and inflation is remaining within their intended constraints. The Fed is currently maintaining policies to keep the growth rate of the M1 money supply in check. If the money supply were to increase at a more rapid rate, than it is likely that inflation would also increase.

3. Is stability in the general level of prices through time important? Why or why not? Should price stability be the goal of monetary policy? Explain your responses.

Price stability in an economy is an essential quality for sustained growth. It is one of the key aspects that investors, both domestic and foreign, look at to determine whether or not to invest in the economy. If the price is unstable, than investors, especially foreign investors, do not see the economy as stable enough to risk their money in, and therefore invest elsewhere. This obviously is lost economic activity that can cause ripple effects across the market. When the general price level is stable however, the economy becomes appealing to investors, and causes them to spend their money in the market. This confidence that investors gain is a huge asset to economic growth and development. When people and businesses are confident that their money is going to be put to good use, they are much more likely to spend it. Domestically, price stability is important for the government, and the Fed to be able to maintain fiscal policies. The Central Bank is also affected by the stability of prices when it makes monetary adjustments and investments. Therefore, it is vital for the Fed to monitor and attempt to stabilize prices as much as possible.

4. Compare and contrast the impact of an unexpected shift to a more expansionary monetary policy under rational and adaptive expectations. Are the implications of the two theories different in the short run? Are the long-run implications different? Explain.

When monetary policy is created, there are 2 popular theories that guide the actions of decision makers. One of these policies is Rational Expectations. The theory of Rational Expectations is based on the presumption that the economic future of a market can be systematically predicted based on hypothesis and rational thought. This is the most widely used theory by today’s economic analysts and decision makers at the Fed. The second theory is Adaptive expectations. This theory is based on the idea that to predict an economy’s future, one has to analyze its past. The Impact of an unexpected shift to a more expansionary monetary policy under adaptive expectations will temporarily stimulate output and employment. Under Rational expectations, the same situation would result in little to no change in output.

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