Suppose, as part of an active monetary policy, the Federal Reserve sells governm
ID: 2729485 • Letter: S
Question
Suppose, as part of an active monetary policy, the Federal Reserve sells government and other securities from its existing portfolio holdings to the banking and financial sectors and the non-bank public. Suppose also that the banking sector is fully “loaned up,” meaning that it is holding no excess reserves. Trace through the expected consequences of this secondary market action on the banking system - reserves, loanable and investable funds, and deposits; financial markets - bond and stock prices, and interest rates; inflationary pressures; credit-sensitive spending; and the general state of the economy as measured by real GDP (or real income) and unemployment. Under what circumstances would the Federal Reserve do this?
Explanation / Answer
Sales of government securities shrink the funds available to lend and tend to raise the federal funds rate. Policymakers call this tightening, or contractionary monetary policy. Again, if the economy were a car and the FOMC(The Federal Open Market Committee) its driver, contractionary policy would be like lightly tapping on the brakes, not enough to stop the car, but rather to slow its momentum a bit.
The effectiveness of these policies vary.
In effect, higher interest rates make future cash flows less valuable in today’s rupees, and thus reduce the intrinsic value of a stock. The second negative impact of higher interest rate on stocks is that it makes investments other than stocks, such as bonds, more attractive i.e, price of bonds increses.
As well, higher interest rates cause the cost of financing capital projects to be higher, so capital investment will be reduced.
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