Question

Explain how open market sales lead to a decrease in aggregate demand. Your explanation should touch on the money supply, interest rates, and specific actions by households and firms that are impacted.

Answer 1

When there is a open market sale the monetary authority of a country is reducing the money supply in the economy. So when the money supply increases the interest rate will go up and this reduce the investment spending, the cost of borrowing is the interest rate and if there is an increase in the interest rate the cost of borrowing will increase and this will reduce the investment spending. Since the investment spending is a component of the aggregate demand the aggregate demand will decline.

When there is a open market sale the money supply decreases in the economy so the people have less money to spend on the goods and services and the consumption spending also decreases and the aggregate demand will decline.

When there is decrease in the money supply it decreases the mominal income of the country so when there is a decrease in income people consume less.

Answer 2

Open market sales refer to the sale of government securities, such as Treasury bonds or bills, by the central bank in the open market. These sales have an impact on the money supply, interest rates, and subsequently, aggregate demand.

When the central bank conducts open market sales, it essentially withdraws money from the economy. The central bank sells government securities to commercial banks and financial institutions, reducing their reserves. As a result, the money supply in the economy decreases.

The decrease in the money supply has several effects. Firstly, it reduces the amount of money available for households and firms to spend and invest. With less money in circulation, households have less purchasing power, leading to a decrease in consumer spending. Similarly, firms have less available funds to invest in new projects, expand operations, or hire new employees.

Secondly, open market sales affect interest rates. As the money supply decreases, there is greater demand for the remaining money in the economy. This increased demand for money leads to a higher demand for loans from commercial banks. To meet this increased demand, banks raise interest rates to discourage borrowing. Higher interest rates make borrowing more expensive for households and firms, reducing their willingness to take on new loans for consumption or investment purposes.

The increase in interest rates further dampens aggregate demand. Higher borrowing costs discourage households from making large purchases, such as buying homes or cars, as the cost of financing these purchases becomes more expensive. Similarly, firms may delay or scale back investment plans due to the higher cost of borrowing, reducing their overall spending.

Overall, open market sales by the central bank result in a decrease in the money supply, higher interest rates, and reduced spending by households and firms. These factors collectively lead to a decrease in aggregate demand, as both consumption and investment expenditures decline. This decrease in aggregate demand can have implications for economic growth, employment levels, and overall economic activity.