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 increase initially (before the affects of the multiplier) if investors borrow and spend all the newly available credit?

Instructions: Enter your response as a whole number.

$ billion

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

Explanation / Answer

(a) If Fed decides to purchase $100 billion worth of government securities in the open market and proceeds of such purchase are deposited directly into the banking system by the sellers then in that case deposits with banking system will increase by $100 billion.

Deposits with banking system are part of M1. So, increase in deposits with banking system will increase the M1 as well.

Thus, M1 will initially increase by $100 billion.

Hence, the correct answer is option (4).

(b) Total increase in reserves with banks = $100 billion

Reserve requirement = 20% or 0.20

Required reserves = Increase in reserves * Reserve requirement = $100 billion * 0.20 = $80 billion

Excess reserves = New reserves - Required reserves = $100 billion - $20 billion = $80 billion

Money multiplier = 1/Reserve Requirement = 1/0.20 = 5

Increase in lending capacity = Excess reserves * money multiplier = $80 billion * 5 = $400 billion

Thus, the banking system's lending capacity will increase by $400 billion.

(c) Investors tends to borrow more when interest rate falls as this reduces their real cost of borrowing.

Secondly, when money supply increases, interest rates tends to decrease.

So, interest rate must fall to induce investors to utilize this expanded lending capacity.

(d) The lending capacity of banking system has increased by $400 billion. If investors utilize this lending capacity in full then investment in economy will increase by $400 billion. Investment is an component of aggregate demand.

So, before the effect of multiplier kicks in, aggregate demand will initially increase by $400 billion, if investors borrow and spend all the newly available credit.

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