Question

If the Federal Open Market Committee were seeking to stimulate the economy, describe the actions they would take to seek to accomplish this.

What impact will these noted actions have on the interest rates prevailing in the economy for new loans?

Answer 1

The Federal Open Market Committee is responsible for controlling the flow of money in the economy by directly purchasing or selling bonds in the open markets.

During a recession, the flow of money in the economy is low and the total demand for goods and services suffers because of the same. As a result, producers lose their incentives of investment which is seriously reduced and people risk losing their jobs.

To correct the situation the currency in circulation needs to be increased by the Federal Reserve. This is done by buying bonds from the open markets which are usually held by institutions such as banks or by other individuals and it creates a situation wherein, the currency in circulation increases.

For example, if a bank holds bonds and the Federal Reserve chooses to purchase the same, the bank is supplied with additional currency and in return the bank gets additional capital which it can then give away as loans to the public at large. This creates a balance in the supply of money which was earlier short and the economy returns back to its normal position.

Now, when we look at the market for new loans, we realize that the currency in circulation for banks is relatively higher than it used to be earlier. This would mean that they can give away loans relatively easily and this results in reduction in interest rates as the availability of funds is relatively higher.

We can thus conclude by saying that the Federal Open Market Committee purchases bonds from the open markets during a recession with the intention of stimulating the economy which increases the banks working capital and as a result of which the interest rates see a rapid reduction.

Please feel free to ask your doubts in the comments section if any.