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Fed policy for maintaining real GDP at its potential

The information below shows the situation in 2010 and 2011 if Fed does not use the monetary policy:  

Year Potential Real GDP Real GDP Price Level
2010 $14 trillion $14 trillion 120
2011 $15 trillion $15.2 trillion 133

a) If Fed wants to keep real GDP at its potential level in 2011 should it use expansionary policy  or a contractionary policy?  Should Fed NY sell or buy Tâ?bills?  How about Fed Dallas and Fed Philadelphia, are they expected to sell or buy Tâ?bills?  

b) If the Fedâ??s policy in keeping real GDP at its potential in 2011, state whether each of the  following will be higher, lower, or the same as it would have been if the Fed had taken no action:  
1. Real  GDP;  
    2. Potential  GDP;  
  3. The  inflation  rate;
  4. The  unemployment  rate  

c) Draw an aggregate demand and aggregate supply  graph to illustrate your answer.   Be sure that your graph contains LRAS curves for 2010 and 2011; SRAS curves for 2010 and 2011;  AD curves for 2010 and 2011, with and without monetary policy action; and equilibrium real GDP and price level in 2011 with and without policy.

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Solution Preview

Notice that potential real GDP is lower than real GDP in 2011. This means that the Fed needs to slow down the economy, or use contractionary monetary policy. It will need to sell T bills, which reduces currency in circulation. All branches of the Fed ...

Solution Summary

The Fed's response to changes in real GDP