Suppose the following table illustrates the values of actual and potential Real GDP, and the price level if the Fed does not vote to change their current policy to be more contractionary or expansionary.
Year Potential Real GDP Actual Real GDP Price level Inflation
Y* Y P π
2000 $12.0 trillion $12.0 trillion 110 2%
2001 $13.0 trillion $12.8 trillion 104 1%
a. What problem occurs in the economy in year 2001? What type of recession or economic expansion is present? Illustrate the state of the economy in year 2001 graphically.
b. Given the state of the economy in 2001, assuming the natural unemployment rate of 5%, find the output gap in percentage points and the actual unemployment rate. What type of unemployment is present?
c. If the Fed wants to keep actual Real GDP in 2001 at its potential level, what type of monetary policy should the Fed use? What would be the goal of monetary policy?
d. Should the Fed raise or lower the target for the federal funds rate?
e. Use the Taylor rule and find the new target for the FFR in 2001 given the output gap and actual inflation in year 2001
f. Should the Fed purchase or sell government bonds to meet the new target for the federal funds rate?
g. Use the supply and demand for bonds concept, explain and illustrate the effect of the Fed action on:
- Supply or demand for bonds
- Bonds prices
- Interest rates associated with these bonds
h. Use the money market diagram to explain and show graphically the Fed open market operations effect on:
- The money supply in the economy
- The short-term interest nominal interest rate.
- Explain what will happen to the real interest rates
i. Use the basic AD-AS diagram to explain verbally and illustrate graphically how the monetary policy chosen by the Fed moves the economy to the full employment level of Real GDP
k. What would be the benefit, the cost of moving the economy to the potential Real GDP? Use the short-run Phillips Curve to illustrate the cost.