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Trouble understanding Monetary Policy

-If the Fed cuts the quantity of money, explain how each of the following items change.

a) Business' purchases of new capital equipment.
b) Households' purchases of new cars and houses.
c) Foreign purchases of U.S.-made goods and services.
d) Americans' purchases of Canadian-made goods and services.

-What is the multiplier effect of monetary policy?

-How does it work?

-How does the size of the expenditure multiplier influence the size of the multiplier effect of monetary policy?

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1. Fed reduces money supply.

First, there is a short run change and a long run change, we will look at the short run first.

In the short run, when money supply reduces, the amount of money people has decreases. In the short run, price remains the same, so reducing money supply is essentially increasing prices. Consider the example that you have an $100 weekly income, if the Fed reduces money supply, your boss now only has $50/wk to pay you. Given that price level remains the same, the amount of goods you can purchase has reduced. Now, because you have less money, you need to borrow, so interest rate goes up. To summarize, in the short run, if money supply goes down, interest rate goes up.

In the long run, price level will adjust. Because people are poorer, they consumer less goods, and price of goods fall, so that the amount of goods people can buy after the reduction in money supply is the same as the ...

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Trouble understanding Monetary Policy

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