Question

8. a) Explain what the Fed will do when implementing an expansionary monetary policy using open market operations.

b) Be as specific as possible about the ways in which this policy will conditions in our economy.

Answer 1

a) In the open market operations, Fed will try to purchase treasury securities of the government from securities dealers in the bond market via commercial banks. This infuses money in the banking system, which is expected to raise deposits of the commercial banks of banks, businesses, and individuals who were selling these securities. Now that the banks have more deposits, this increases their lending ability as more excess reserves are now available for loans.

b) This will reduce the rate of interest offered by banks in order to attract borrowers which implies that the federal funds rate also decreases. When system has more loans, consumption and investment spending are increased. This will raise the aggregate spending and so AD will shift to the right. Price level and output both will increase as a result.