Refer to Table 26-6. Suppose the table above illustrates the values of real and potential GDP and the price level if the Fed does not vote to change their current policy to be more contractionary or expansionary

Question

If the Fed wants to keep real GDP at its potential level in 2017, should the Fed use a contractionary or expansionary policy? Should it raise or lower its interest rate target? How should it conduct open market operations to achieve its goal?

Answer 1

The information in the table indicates that if the Fed does not vote to change their current policy to be more contractionary or expansionary, then real GDP will rise above potential GDP in 2017. To keep the economy at potential GDP in 2017, the Fed should use contractionary monetary policy. The Fed should raise its interest rate target. This would mean that the Fed should direct the trading desk to sell U.S. Treasury bills. If this is done, reserves in the banking system will decrease, banks will decrease the number of loans, and this should lower the money supply and raise the interest rate.