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  1. The information below shows the situation in 2017 and 2018 if Fed does not use the monetary policy:

Year

Potential Real GDP

Real GDP

Price Level

2017

$14 trillion

$14 trillion

120

2018

$15 trillion

$15.2 trillion

133

  1. a) If Fed wants to keep real GDP at its potential level in 2018 should it use expansionary policy or a contractionary policy? Should Fed sell or buy T-bills
  2. b) If the Fed’s policy is keeping real GDP at its potential level in 2018, state whether each of the following will be higher, lower, or the same as it would have been if the Fed had taken no action:
  3. Real GDP; ii. Potential GDP; iii. The inflation rate; iv. The unemployment rate
  4. c) Draw an aggregate demand and aggregate supply graph to illustrate your answer. Be sure that your graph contains LRAS curves for 2017 and 2018; SRAS curves for 2017 and 2018; AD curves for 2017 and 2018, with and without monetary policy action; and equilibrium real GDP and price level in 2018 with and without policy.
  1. Consider an economy described by the following equations:

Y=C+I+G

Y=5000

G=1000

T=1000

C=250+0.75(Y-T)

I=1000-50r

  1. a) In this economy, compute private saving, public saving, and national saving.
  2. b) Find the equilibrium interest rate
  3. c) Now suppose that government increases its spending by 25% more. Compute private saving, public saving and national saving.
  4. d) What happens to interest rate? How about private businesses investment
  5. “The global supply of oil might be about to shrink, and prices rise. Saudi Arabia’s Energy Minister announced on Nov. 11 the kingdom would cut its oil production by 1,500,000 barrels per day in December. In the same month, the 15 nations that make up OPEC will likely confirm a coordinated move to push prices higher. Add the imposition of U.S. sanctions on Iran’s oil exports that came into force on Nov. 5, lower production in crisis-plagued Venezuela and the risk that unrest may lower production in places like Libya and Nigeria, and oil could be set for a rebound.” Note this paragraph is taken from a Risk Report on Time magazine. 

It’s January 2019. Unemployment is still less than 4 percent. Fed increased the federal funds rate target in December 2017 to 2.25-2.50 % and announced more rounds of interest rate increases in 2019. The national debt has crippled to $21.6 trillion.

You are an adviser to the White House. The President asks you to do a report about the impact of Saudi Arabia and rest of the countries’ decision on US (what exactly has happened, why everybody is complaining), and what measures could be taken, including monetary and/or fiscal policies. In the end of the memo, the President has written in handwriting: “Please include advantages and disadvantages of all possible options . Your advice is appreciated.”

Note: Although many decisions depend on politics, I expect the focus of your answers to be mainly on the economic aspects.

  1. Suppose that Federal Reserve policy leads to higher interest rates in United States
  2. How will this policy affect real GDP in short run if the United States is a closed economy (no exports and imports)
  3. How will this policy affect real GDP in short run if the United States is an open economy
  4. How will your answer to part b change if interest rates also rise in the other countries around the world.

Steps to reduce real GDP

In that case, the real GDP is more than the potential GDP that means the economy is in the boom phase. Now, one of the direct consequences of using the monetary policy is the impact on the output and inflation of the economy as can be justified by the quantity theory of money. Now, in order to keep the GDP at the potential level, The output needs to be reduced,

That means,

MV=PY where M= Money supply, Velocity of circulation, P= Price level and Y= Real GDP

Now in order to reduce the Real GDP keeping the price level and the velocity constant, the Money supply needs to be reduced in order to hold the equality. Therefore, the government should use a contractionary policy (Johnson, 2017).

The Fed should sell T- bills in the market so that it can suction off the money from the market.

  1. b)
  2. i) The Real GDP will be lower than the shown figure as it is the main goal of the Fed.
  3. ii) The potential GDP is derived from the aggregate demand of the economy. There is four component of aggregate demand which includes consumption, investment, government spending, and net export. The contractionary monetary policy reduces consumer spending and hence the aggregate demand which in turn reduces the potential GDP of the economy.

iii) Through the quantity theory of money, when the money supply reduces, the consumers have less money to spend on and the aggregate demand shifts to the left leading to a reduction in overall price and the inflation (Agénor & Montiel, 2015). Lower the income less will be the demand for goods and services in the economy and hence the prices will be low that eventually will bring down the inflation level in the economy.

  1. iv) With the chosen strategy of the Fed, the reduced money supply would reduce the aggregate demand in the market that eventually will reduce the level of production and hence the labour requirement. Therefore the Fed’s strategy would increase unemployment. The labours of the market will not have much production processes to work on the economy will be shrinking (Goodwin et al.2015).

The equation is

Y= C+I+G

Now the private savings,

Y –T-C

Putting the values,

5000-1000-250-0.75(Y-T)= 3750-0.75(5000-1000) = 750

The public savings,

T-G= 1000-1000= 0

The national savings= Private savings+ public savings

= 750+0= 750

b)

In the equilibrium, the national savings = investment

Therefore,

750=1000-50r

=> r=5

c)

The initial government spending was = 1000. It increases by 25%

Now the new government spending is 1250

Therefore, private savings

Y –T-C

5000-1000-250-0.75(Y-T)= 3750-0.75(5000-1000) = 750

The public savings is,

T-G= 1000-1250= -250

Therefore the national savings= private savings + the public savings

=750-250= 500

d)

Now the new equilibrium is

National savings= investment

500= 1000-50r

=> r= 10

Therefore the interest rate increases to 10.

As the interest rate increases, the rate of return from the investment also increases. This makes investors more likely to invest in private businesses (Rezai & Stagl, 2016). Therefore the private business investment increases with the rise in the investment following the rise in government spending.

Currently, the policies of the US government to sanction few of the countries to import oil from Iran have not only increased the instability in the global oil prices but it has also increased the chances of increasing gas prices in the market of USA. Apart from that, the decision from the side of the OPEC countries to increase the price of oil and reduce the production has also put a pressure on the US government and the price of gas in the market (Bremmer, 2018).

The advice would be to increase the sanction to at least 250 days that would allow the countries importing oil from Iran to shift their demand from the other country. The advantage of this strategy is that it will allow the prices of gas in the USA to remain low for a longer period of time.

Another measure that can be taken to reduce the complaints from the countries and keep a low pressure on the gas prices of USA is it can improve the relationship with the diplomats of Saudi Arabia (Romer, 2016). The biggest advantage of this strategy is that it will allow the government of USA to have a better supply of oil despite the reduction in the production of oil in the global market. The Saudi Arabian government, given its recent images and activities, would love to improve the relationship with the USA. However, the disadvantage of this strategy is that the government will lose control over the other parts of the oil market that may become the reason for increasing fuel prices in the USA.

If the interest rate increases, the demand for investment within the economy would increase. Investment is an important part of aggregate demand of the nationwide surge in the level of which would increase the aggregate demand in the economy of USA. Therefore the real GDP would increase with the increase in the interest rate in the economy.

  1. b) Now if the economy was an open economy investors from the foreign market would also be interested in investing their money in the markets of USA. The investment component would go up leading the aggregate demand to rise. Apart from that, increase in interest rate in the US economy would also increase domestic investment leading to a huge amount of investment in the economy of the USA (Cohn, 2015).  The real GDP of the economy would rise reducing the unemployment rate in the economy.
  2. c) If the interest rate around the world also rises, the foreign investment component would reduce from the previous case. The impact on the economy would be the same as the consumption would go down balancing the aggregate demand of the economy.

Reference

Agénor, P. R., & Montiel, P. J. (2015). Development macroeconomics. Princeton University Press.

Blanchard, O., & Johnson, D. R. (2017). Macroeconomics. London usw.: Prentice-Hall International Inc.

Bremmer, I. (2018). https://time.com. Retrieved from https://time.com/5455485/mohammed-bin-salman-image/

Cohn, S. M. (2015). Reintroducing Macroeconomics: A Critical Approach: A Critical Approach. Routledge.

Goodwin, N., Harris, J. M., Nelson, J. A., Roach, B., & Torras, M. (2015). Macroeconomics in context. Routledge.

Johnson, H. G. (2017). Macroeconomics and monetary theory. Routledge.

Rezai, A., & Stagl, S. (2016). Ecological macroeconomics: Introduction and review. Ecological Economics, 121, 181-185.

Romer, P. (2016). The trouble with macroeconomics. The American Economist.

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