Macroeconomics

2. What is the basic objective of monetary policy? State the cause-effect chain through which monetary policy is made effective. What are the major strengths of monetary policy? Why is monetary policy easier to undertake than fiscal policy?

- The basic objective of monetary policy is to assist the economy in achieving a full-employment, non-inflationary level of total output. Changes in the money supply affect interest rates, which affect investment spending and therefore aggregate demand. The major strengths of monetary policy are its speed and flexibility compared to fiscal policy, the Board of Governors is somewhat removed from political pressure, and its successful record in preventing inflation and keeping prices stable. The Fed is given some credit for prosperity in the 1990s. The major weaknesses are that the Fed’s control may weaken with bank reforms and electronic banking that diminish the importance of the traditional money supply, changes in velocity may offset changes in money supply and weaken monetary policy results, and monetary policy has asymmetrical impact – it combats inflation better than it helps recovery from recession.

5. Suppose that you are a member of the Board of Governors of the Federal Reserve System. The economy is experiencing a sharp and prolonged inflationary trend. What changes in (a) the reserve ratio, (b) the discount rate, and (c) open-market operations would you recommend? Explain in each case how the change you advocate would affect commercial bank reserves, the money supply, interest rates, and aggregate demand.

- (A) Increase the reserve ratio. This would increase the size of required reserves. If the commercial banks were fully loaned up they would have to call in loans. The money supply would decrease, interest rates would rise and aggregate demand would decline.

(B) Increase the discount rate. This would decrease commercial bank borrowing from the Fed. Actual reserves of the commercial banks would fall, as...