Suppose the American economy is in long-run equilibrium. Now assume that the Fed decides to sell government bonds to the public.
1) What is the effect on the money supply? Use the diagram of market for money to show how the Fed’s action affects the federal funds rate (or the nominal interest rate). Also explain the intuition behind the change in the change of fed funds rate/nominal interest rate.
2) Assume there is no change in expected inflation in the short run, what happens to consumption, investment? Explain. (we assumed closed economy)
3) Using your conclusions from part 2), explain and show graphically how the Fed’s action affects aggregate demand. What happens to the price level and to aggregate output in the short run? 4) Explain why the economy in part 3) is not in a long-run equilibrium. Explain the transition to the long run. Illustrate your answers using a diagram.
4) Explain why the economy in part 3) is not in a long-run equilibrium. Explain the transition to the long run. Illustrate your answers using a diagram.