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Monetary Policy and an Expansionary Gap

Suppose the Fed wishes to use monetary policy to close an expansionary gap.
a. Should the Fed increase or decrease the money supply?
b. If the Fed uses open-market operations, should it buy or sell government securities?
c. Determine whether each of the following increases, decreases, or remains unchanged in the short run: the market interest rate, the quantity of money demanded, investment spending, aggregate demand, potential output, the price level, and equilibrium real GDP.

Solution Preview

a) An Expansionary Gap means that consumers are spending more than what is needed in the economy, i.e. the Aggregate Demand is higher than the Aggregate Supply. This would causes prices to rise (i.e. cause inflation). With ...