Monetary Policy Monetary policy is the action of the Federal Reserve (the Fed) to prevent or address extreme economic fluctuations. The Fed uses its monetary policy tools to influence equilibrium interest rates in the money market through its control of bank reserves. The Fed lowers interest rates through expansionary monetary policy to prevent or address recessions, and it raises interest rates through contractionary monetary policy to prevent or address inflation. Monetary policy is transmitted to the economy through changes in aggregate demand. Monetary policy will have both short-run and long-run effects in the economy. In the following figures, long-run aggregate supply, short-run aggregate supply, and demand curves are represented by LRAS, SRAS, and AD. Contractionary Gap Price LRAS Level SRAS a PI AD Q1 Qp Real GDP 1. Suppose that initially the economy is at the intersection of AD and SRAS as shown above. a. What monetary policy can the Fed implement to move the economy to full-employment? b. If the Fed is going to use open market operations, what should it do? c. In the short run, what is the effect on nominal interest rates? Explain. d. What effect will the change in interest rates have on bond prices? e. In the short run, what happens to real output? Shift the curve on the graph above to show how the Fed's action results in a change in real output and explain why the shift occurs. f. In the short run, what happens to the price level? Explain how the Fed's action results in a change to the price level. 3