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    Adopting a Contractionary Policy

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    1) By law the Federal Reserve is required to pay attention to both unemployment and inflation. How does the Federal Reserve accomplish these goals?

    2) What are the pros and cons of using contractionary and expansionary monetary policy tools under the following scenarios: depression, recession, and robust economic growth?

    3) What is more appropriate of the tools today?

    Please provide references to help with my understanding of these questions.

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    Solution Preview

    1. The Fed is required to pay attention to both unemployment and inflation. Though not explicit, there is an implicit understanding that the Fed like every other major central bank targets moderate inflation rate, around 2%, and moderate unemployment rate. The natural rate of unemployment, or NAIRU (Non-Accelerating Inflation Rate of Unemployment) in the US is about 4.5%, and if the Fed is able to ensure an inflation rate of about 2% with 4.5% unemployment they are happy with the outcome.

    The problem arises when either inflation rises, or unemployment rises, or both rise. In case it is just inflation going up it is usually accompanied by falling unemployment (the short-run Phillips Curve), and hence in such a case the Fed usually implements a contractionary monetary policy by reducing money supply and increasing interest rate in the market. The higher interest rate is then expected to lower consumption and investment, and make imports costlier, thus reducing aggregate demand and reducing inflation. This is usually accompanied by a slight increase in unemployment rate.

    In case unemployment rate rises but inflation is under control it usually indicates towards a recession and the Fed in such a case raises money supply, and lower interest rate. Lower interest rate is expected to raise consumption, investment, and net ...

    Solution Summary

    Adopting a contractionary policy is analyzed.