Question

Suppose the economy is currently suffering from an output gap and the Federal Reserve uses an expansionary monetary policy to close that gap. Describe the short-run effect of this policy on the following.

a. The money supply curve

b. The equilibrium interest rate

c. Investment spending

d. Consumer spending

e. Aggregate output

Short answer

a. The money supply will be increased.

b. The equilibrium interest rates will fall.

c. The spending on investment will rise.

d. The spending by the consumer will increase.

e. The aggregate output will increase.

Step-by-step solution

Explanation for part (a)

To fill the output gap, Federal reserves use the expansionary monetary policy under which the aim is to increase the demand so that sufficient output could be produced to meet that increased demand and the output gap may be filled.

Thus, to increase demand, the money supply is increased since increased money supply will increase the purchasing power of the people, and hence, they will demand more. The increased demand will result in increased output eventually.

Explanation for part (b)

The demand for money is inversely related to the interest rates. Thus if interest rates are reduced, then the demand for the money will increase; reducing interest rates is the job of the Federal reserve which comes under the expansionary policy. Now, to accommodate the demand, the supply of money will also be increased, which will increase the demand and eventually the aggregate output of the economy.

Thus if the aggregate level of output is to be increased, then the interest rates must be reduced.

Explanation for part (c)

To increase the output, the demand needs to be increased, and increasing demand could only be possible if people are vested with the required purchasing power to demand more.

The purchasing power directly depends upon the consumer's income, so income needs to be increased by creating more employment opportunities to increase the purchasing power.

Employment opportunities in the economy can only be created if investment activities are on the part of the government and the private bodies. When the Federal Reserve lowers the interest rates, entrepreneurs will borrow more funds to invest.

Thus, if investment spending increases, it will increase employment, resulting in increased incomes and eventually leading to increased output.

Explanation for part (d)

As mentioned above, the main key to increasing output is increasing demand. The expansionary monetary policy will result in increased employment opportunities, as mentioned above, which will result in increased income. This increased income will eventually result in increased consumer spending on the consumer.

Explanation for part (e)

As the Federal Reserve engages in the expansionary monetary policy, it will increase the money supply in the economy, which will reduce the interest rates. Lower interest rates will result in increased investment activities, which will increase employment and income, leading to increased purchasing power or spending on the consumer.

The increased consumer spending means increased demand, which will result in increased aggregate output eventually.