What action could the Fed take to close a contractionary gap that resulted from a decrease in aggregate demand?   

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pohnpei397 eNotes educator| Certified Educator

The Fed is the popular name for the Federal Reserve.  This is the central bank for the United States.  The Fed is in charge of the monetary policy for the United States.  Therefore, the actions that it can take are those types of monetary policy that lead to increases in aggregate demand.

There are three main types of expansionary monetary policy.  All of them are intended to increase the money supply and thereby allow aggregate demand to increase.  The Fed can lower the required reserve ratio on banks.  This would mean that banks could lend out more money.  This would allow people to borrow more money to buy consumer goods and it would allow businesses to borrow for the purpose of investing.  The Fed can lower interest rates.  This, too, makes borrowing easier.  Finally, the Fed can buy government securities on the open market.  When it does this, it buys government debt from banks.  This puts money into the banks, thus giving them more money to lend out.  Once again, it becomes easier to borrow.

Overall, then, the Fed can take three main types of action to increase the money supply and thereby increase aggregate demand so as to close the contractionary gap.