Suppose the Fed decided to purchase $100 billion worth of government securities

Question

Suppose the Fed decided to purchase $100 billion worth of government securities in the open market which are directly deposited into the banking system. What impact would this action have on the economy? Specifically, answer the following questions:

(a) How will M1 be affected initially?

(b) By how much will the banking system’s lending capacity increase if the reserve requirement is 20 percent?

Instructions: Enter your response as a whole number.

$ billion

(c) Must interest rates rise or fall to induce investors to utilize this expanded lending capacity?

(d) By how much will aggregate demand initially increase if investors borrow and spend all the newly available credit?

Instructions: Enter your response as a whole number.

$ billion

(e) Under what circumstances would the Fed be pursuing such an open market policy?

(f) To attain those same objectives, what should the Fed do with the

(i) Discount rate?

(ii) Reserve requirement?

No initial change to M1 Increase by $100 billion Decrease by $100 billion Not enough information to answer

Explanation / Answer

(a) How will M1 be affected initially?

Solution: Increase by $100 billion

Explanation: M1 will rise by $10 billion, on an assumption that the sellers of the securities hold the proceeds as cash or deposit it in a transactions account.

(b) By how much will the banking system’s lending capacity increase if the reserve requirement is 20 percent?
Solution: $80 billion

Explanation: 80 billion

Money multiplier = 1 / required reserve ratio = 1/0.20 = 5

Lending capacity = 0.80 * $100 billion = 80 billion

(c) Must interest rates rise or fall to induce investors to utilize this expanded lending capacity?

Solution: Fall

Explanation: Interest rates should fall to entice the investors to avail the expanded lending capacity. Lower interest rates indicates smaller amounts of interest payments on loans with banks.

(d) By how much will aggregate demand initially increase if investors borrow and spend all the newly available credit?
Solution: $400 billion

Explanation:

Money multiplier = 1 / required reserve ratio = 1/0.20 = 5

Increase in aggregate demand = lending capacity * money multiplier = 5* 80 billion = 400 billion

(e) Under what circumstances would the Fed be pursuing such an open market policy?

Solution: FED would pursue recession with a target to stimulate the economy by increasing aggregate demand

(f) To attain those same objectives, what should the Fed do with the

(i) Discount rate?

Solution: decrease

Explanation: To increase aggregate demand, the Fed would lower the discount rate

(ii) Reserve requirement?

Solution: decrease

Explanation: To increase aggregate demand, the Fed would decrease the discount rate

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.