Question

Congratulations! You have been appointed adviser to the Federal Reserve Bank.

Answer 1

Answer:

a. The fed should buy securities worth 21.

b. They could also reduce discount rate and reserve requirement.

c. This policy will cause the money supply, price level and output level to increase.

d. Increase in demand will cause imports to increase and will create a trade deficit and inflation.

Explanation:

a. The reserve ratio is 30% or 0.3.  

The fed needs to increase the money supply by 70.  

The fed can increase the money supply by buying securities in the open market.  

The fed needs to buy securities worth

= $\frac{\Delta Money\ Supply}{RR}$

= $\frac{70}{0.3}$

= 21.03

So, fed needs to sell securities worth 21.  

b. Other than open market operations, other tools that the fed can use to increase money supply in the money is reduce the discount rate and reserve requirement ratio.  

c. This increase in the money supply makes lending cheaper. As a result, the investment will increase. This will cause aggregate demand to increase. The price and output level will increase.  

d. According to the structural stagnation model, the rightward shift in the aggregate demand will lead to an increase in consumer spending. But at the same time imports will increase as well. This will cause the trade deficit to increase and may lead to no increase in domestic production. An increase in the money supply can also lead to inflation.