Economics Micro & Macro (CliffsAP)

Problems the Fed Encounters

Part of the responsibility of being the central monetary authority of the United States is creating aid for macroeconomic
instability. From inflation to consumer expectations, the Federal Reserve deals with a variety of problems. The follow-
ing sections describe how the Fed deals with them.

Demand-Pull Inflation

To remedy demand-pull inflation, the Fed calls for a policy that discourages aggregate demand. Policymakers can imple-
ment contractionary, or tight, monetary policy. The Fed can decrease the money supply and cause interest rates to rise,
which in turn discourages investment and reduces aggregate demand. Once aggregate demand is reduced, GDP/output
will stabilize, and so will the price level. Figure 6-2 depicts the economy’s reaction to a tight monetary policy.

Figure 6-2

On the other hand, if policymakers decide to stimulate aggregate demand, they elect to increase the money supply,
which in turn decreases interest rates. This then provides incentives for consumers to spend money. Figure 6-3 illus-
trates an economy after the Fed has implemented expansionary, or loose, monetary policy.

Figure 6-3

Price

Level

AS

AD^1

Output/GDP

AD^2

Price

Level AD^2

AS

Output/GDP

AD^1

Monetary Policy