Question

What would happen to P and Y in the short run in the AS-AS model where AD is based on IS-LM if the Fed buys a large quantity of bonds?

Answer 1

The Federal Reserve has the authority to implement the monetary policy and so it can tweak the interest rates or can alter the money supply as per the policy. The Fed can undertake open market operation by which it can either sell the bonds or can purchase it from the market.

If the Fed purchases a large quantity of the bonds from the market then it will exchange it for the cash and it means then it has supplied liquidity or increased the money supply in the market. The supply of the bonds will be lower and its price will rise.

A higher liquidity or supply of the money will increase the quantity of the loanable funds. As the banks will have more loanable funds so the interest rate will drop. The lower interest rate means the cost of borrowing is lower and that will encourage leveraged buying and consumption. Further, the firms also find it cheaper to expand production and they will take benefit of lower borrowing cost through increasing the investment.

A higher level of consumption will increase the aggregate demand in the economy and that will shift the curve to the right. The output or GDP will also rise because of this. However, as the economy will take time to adjust the supply for increased demand so the price level will rise in the economy.