Question

1. The economy is in a recession. The FED engages in an open market operation (OMO). Explain in detail how the economy will react.
   1. Explain the OMOs impact on asset allocations and the prices of securities;
   2. Explain how the OMO will impact the real economy,
   3. explain each step of the adjustment process,

graph the process.        

Answer 1

a. Interest rates are directly affected by OMO operations. in case of recession, the FED would go for the expansionary policy intended to increase the money supply. the higher money supply reduces the interest rates. the interest rates are inversely related to the bond prices due to the opportunity cost. So when the interest rates go down, the existing bonds would become more valuable than the new bonds with a lower coupon rate. so in order to make the people buy it, the price of the new bonds must fall so that the return on these would become equal.  (see the process in c)

b. The OMO in this case of recession would be expansionary in nature, which increases the money supply in the economy. the higher money supply causes a decline in the interest rates. the lower interest rates thus stimulate the investment and consumption as the lower interest rates mean low cost of taking a loan and hence the business or the consumers can afford more loans. The consumption and investment being the component of GDP tend to increase the latter with the initial increase in both and hence the economy grows. (see the process in c)

c. In Open Market Operations, the Fed usually buy or sell the US Treasury securities in order to affect the money supply. In case of recession, the fed would likely to go for the expansionary monetary policy wherein the Fed would buy the US treasuries. this act of buying treasuries would cause an increase in the reserves with the banks. the change in the reserves would then make the bank to change its lending activity as with more reserves, the banks would be ready to make more loans to the economy. The change in bank lending affects the money supply via checkable deposits as more loans mean more deposits. The larger supply of loans would also reduce the interest rates in the economy. the lower interest rate would make taking loans cheaper and thus the businessmen would make more investment and so are the consumers intended to buy using a loan such as durable goods. the larger consumption and investment (being a component of GDP) tends to boost the production and thus increase the output in the economy.

where Md is the money demand curve while Ms is the money supply curve and Ms' is the new money supply curve.