Question

Suppose that the Federal Reserve is concerned that the US economy is producing above the natural rate of output. What could it do to return the economy back to the Natural Rate of Output?

A. Sell bonds to lower the interest rate
B. Sell bonds to raise the interest rate
C. Buy bonds to raise the interest rate
D. Buy bonds to lower the interest rate

Answer 1

The Federal Reserve can use contractionary monetary policy by selling bonds to return the economy back to the natural rate of output.

Step-by-step explanation:

The Federal Reserve can use contractionary monetary policy to return the economy back to the Natural Rate of Output.

1. To carry out a contractionary policy, the Fed sells bonds. This reduces the money supply and raises the interest rate.
2. The higher interest rate reduces investment and induces a greater demand for dollars, which reduces the supply of dollars and boosts the exchange rate.
3. These changes in the bond market, money market, and currency market shift aggregate demand to the left, returning the economy back to the natural rate of output.