Question

Assume the economy is operating at the full-employment level of output.

A) The Federal Reserve decides to decrease the discount rate. Explain how each of the following is impacted as a result of the Fed's action:
i) Nominal interest rates
II) Aggregate demand
III) Price level
b) Assume the Fed’s action is successful in changing the economy. Using a correctly drawn and labeled Phillips curve, show and explain how this policy will affect each of the following as the economy approaches a new equilibrium:
I) the Phillips curve
ii) the natural rate of unemployment

Answer 1

A) The Federal Reserve decides to decrease the discount rate. Explain how each of the following is impacted as a result of the Fed's action:

i) Nominal interest rates ⇒ IS REDUCED

II) Aggregate demand ⇒ INCREASES, SINCE MONEY SUPPLY INCREASES AND INTEREST RATES DECREASE, WHICH LEADS TO AN INCREASE IN INVESTMENT AND INCREASE IN TOTAL GDP

III) Price level ⇒ INCREASE, SINCE AN EXPANSIONARY MONETARY POLICY TENDS TO INCREASE THE INFLATION RATE

B) Assume the Fed’s action is successful in changing the economy. Using a correctly drawn and labeled Phillips curve, show and explain how this policy will affect each of the following as the economy approaches a new equilibrium:

I) the Phillips curve ⇒ A SHIFT ALONG THE CURVE WILL OCCUR FROM POINT A TO B. UNEMPLOYMENT RATE DECREASES AND INFLATION RATE INCREASES.

ii) the natural rate of unemployment ⇒ DECREASES TO AN EVEN LOWER LEVEL