1) When the economy is close to or at full employment why is it difficult for the Fed to decide whether or not to change its interest rate target in the federal funds market?

2) Explain why monetary policy makers believe that it is important to start restraining growth in aggregate demand before there is a noticeable increase in the CPI.

3) Draw an AS-AD diagram to illustrate the effects of rising inflation expectations on an economy threatened by inflationary growth in aggregate demand. Explain your diagram clearly.

4) Explain why expansionary monetary policy may be relatively ineffective and slow in helping an economy recover from a serious recession

5) Draw an AS-AD diagram to illustrate the results of a successful expansionary monetary policy.

6) Assume that workers, employers and investors all believed that inflation in the coming year would equal the annualized rate of inflation experienced in the past 6 months. Also assume that workers had been receiving nominal wage gains of 5% during a several year period where the annual inflation rate was 2%. and worker productivity growth was 3% per year. Now assume that a decline in the unemployment rate below NAIRU creates conditions where workers push for an annual real wage increase of 4%. Also assume that labor productivity growth declines to 1% per year as unemployment is squeezed below normal frictional & structural levels.

a) what rate of nominal wage growth will workers seek at the new low unemployment rate?

b) how fast will firms have to raise prices given your answer in (a) in order to protect profit margins?

c) if the rate of inflation in (b) occurs and the Fed allows AD to grow fast enough to maintain the unemployment rate below NAIRU for another year, what rate of nominal wage growth will workers seek in the following year?

d) if the rate of inflation in (b) had persisted for 6 months or more, how large an increase in the federal funds rate would be needed to increase the level of real interest rates in the economy?

7) Is the Fed currently pursuing an expansionary, neutral, or contractionary monetary policy? What if any difficulties do you think may be encountered in implementing the current policy being pursued by the Fed to cope with current dilemma on its next action at the point of close to full employment of the economy?