Level Output
Using open market operations to close an inflationary gap, what happens to equilibrium output and price level?
I’m doing a problem in economics, and I need help. Please read EVERYTHING below:
Using open market operations, the Fed closes an inflationary gap. In other words, the Fed uses open market operations by selling bonds (contractionary monetary policy) to reduce the money supply.
What steps does the economy goes through to move to the new equilibrium output and price level? How does this look on a graph?
1) Fed bids bonds on money-market.
2) Monetary institutions purchase bonds and pay money to FED.
3) Money supply reduced now.
4) Fall in money supply increases interest rate thus reducing investments in long-run (so AS leftward or upward)
5) Fall in money-supply and consequent increase in interest rate reduces credits availability for consumers thus reducing disposable income in short-run (AD downward or leftward)
As a result in short-run there is fall in inflation (AD shift) and output falls a bit (though depends on model Classical, Keynesian .. etc.) but in long-run.. well monetary policy is ineffective in long-run due to money neutrality.
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