Monetary Policy:

a. On March 16, 2020 the Federal Reserve ordered its trading Desk to undertake open market operations such that the Federal Funds rate would be reduced to, effectively, zero. The economy, however, is still in recession. On April 29, 2020 the Federal Reserve issued a statement indicating that it would maintain this interest rate level "until it is confident that the economy has weathered recent events." The economy remains in recession. The Fed might attempt to stimulate the economy with further expansionary monetary policy. Suppose, however, that the money demand curve starts to flatten out at these low interest rates. Describe what it means for the money demand curve to be completely elastic. If that is the case, what would happen if the Fed tried to expand the money supply further?     

b. We generally assumed that the multiplier from monetary policy is the same as the spending multiplier from fiscal policy (i.e.,  1/(1-MPC) ). In practice, however, the multiplier for  monetary policy is likely smaller than this. What might cause the multiplier from monetary policy to be smaller than we assumed? (Hint: consider the money demand curve.)

 

Monetary Policy:

a.       On March 16, 2020 the Federal Reserve ordered its trading Desk to undertake open market operations such that the Federal Funds rate would be reduced to, effectively, zero. The economy, however, is still in recession. On April 29, 2020 the Federal Reserve issued a statement indicating that it would maintain this interest rate level "until it is confident that the economy has weathered recent events." The economy remains in recession. The Fed might attempt to stimulate the economy with further expansionary monetary policy. Suppose, however, that the money demand curve starts to flatten out at these low-interest rates. Describe what it means for the money demand curve to be completely elastic. If that is the case, what would happen if the Fed tried to expand the money supply further?   

The money demand curve is completely elastic when a small change in price will have a large change in quantity demanded. The reduction of the interest rate will result in an increase in the supply of money. In other words, a small change in interest rate will result in a large change in the supply of money in the economy. If the Fed tried to expand the money supply further, there will be more money in the economy than the quantity demand. When this happens, the economy will go into inflation since firms will increase prices. More precisely, increasing more supply of money in the economy will increase the disposable income of consumers. However, this further supply of money will surpass the real output. This implies that consumers will have more purchasing power but the output or quantity will be limited. Therefore, this will give firms the power to manipulate prices, leading to inflation. Alternatively, when this occurs, individuals will hold up money and wait for the prices to go down.

b.      We generally assumed that the multiplier from monetary policy is the same as the spending multiplier from fiscal policy (i.e., 1/(1-MPC) ). In practice, however, the multiplier for monetary policy is likely smaller than this. What might cause the multiplier from monetary policy to be smaller than we assumed? (Hint: consider the money demand curve.)

The money demand curve is influenced by the changes in the interest rate. The same interest rate determines the money multiplier from the monetary policy. Therefore, the interest rate might cause the multiplier from the monetary policy to be small than we assumed. More precisely, when the federal government imposes regulations to decrease the interest rate, the change night be minimal in the short-run. This is because the interest rate will have a low impact on the money demand curve. This implies that the money demand curve will take time to shift from inelastic to elastic. During this period, the money multiplier from the monetary policy will be small to the extent its impact will not be noticed. In conclusion, the interest rate in the monetary policy influences the monetary multiplier.