Federal Reserve Policy and the Macroeconomy

The Federal Reserve influences aggregate expenditures, employment, and inflation in the economy by changing the level of the money supply, which in turn affects interest rates. Monetary policy -- actions by the Federal Reserve to change the money supply and interest rates, in particular the purchase and sale of government bonds (open market operations) – works in the short run by affecting planned spending and the equilibrium output level in the economy. Changes in output, in turn, affect employment and inflation.

Exploration: How do Federal Reserve actions affect the economy?

The applet above illustrates the Keynesian cross diagram and lists the level of planned aggregate expenditure (PAE) at various levels of output (Y). Short-run equilibrium output is determined at the intersection of the PAE line and the 45-degree line in the Keynesian cross diagram or where PAE=Y in the table. Changes in autonomous expenditure shift the PAE line, leading to an increase or decrease in equilibrium output. You can change the values of autonomous expenditure by dragging the Autonomous Expenditure sliders or the Interest Rate slider with your mouse. Clicking on the "Income Adjustment" button will then show the movement to the new short-run equilibrium level of output. Click the Reset button to restore the original values.

1. What is the initial short-run equilibrium level of output in the economy illustrated above? How do you know? What are the initial levels of consumer expenditures (C), investment (I), government purchases (G), and net exports (NX) at this equilibrium?
   
2. If autonomous consumer spending falls by $500 billion due to declining consumer confidence about the economy, what will be the effect on the short-run equilibrium level of output in the economy? What type of "gap" is created by the fall in consumer expenditures?
   
   
3. Given the scenario in question #2, what can the Federal Reserve do to bring the economy back to equilibrium at potential output (full employment)? What happens to consumer spending, investment spending, and output as a result of the Fed's actions?
   
   
4. If consumers in Japan purchase $200 billion fewer American goods due to a slowdown in the Japanese economy, what effect will this have on the U.S. economy? What would the Federal Reserve do in this situation if they want to keep the U.S. economy operating at potential?
   
   
5. Restore the original values in the model by clicking on the Reset button. If planned investment spending increases by $500 billion, what happens to equilibrium output in the economy? Assuming that the economy was originally at the potential output level, what type of "gap" is created by the increase in consumer expenditures? How should the Federal Reserve respond? Explain.
   
   
6. Based on your analysis of monetary policy in questions #3, #4, and #5, what do you conclude about the Federal Reserve's ability to reduce output gaps in the economy? Can the Federal Reserve really "control" aggregate expenditures and income in the economy? Explain.
   

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