Question

Suppose the Fed decided to sell $350 billion worth of government securities in the open market (assume all payments are are directly deposited into or withdrawn from the banking system). What impact would this action have on the economy? Specifically, answer the following questions:

Instructions: Enter your responses as a whole number. If the lending capacity or aggregate demand falls be sure to include a negative sign (-) with your answer.

a. How will M1 be affected initially?

• increase by $350 billion

• no initial change to M1

• not enough information to answer

• decrease by $350 billion

b. By how much will the banking system’s lending capacity change if the reserve requirement is 10 percent?

     $  billion

c. How must interest rates change to induce investors to utilize this change in lending capacity?

     Interest rates must  (Click to select)  fall  rise  .

d. By how much will aggregate demand initially change if investors change their behavior because of this change in available credit?

     $  billion

e. Under what circumstances would the Fed be pursuing such an open market policy?

• expansion

• recession

f. To attain those same objectives, what should the Fed do with the

     (i) Discount rate?

• increase

• decrease

     (ii) Reserve requirement?

• increase

• decrease

Answer 1

(a) If Fed decides to purchase $350 billion worth of government securities in the open market and proceeds of such purchase are deposited directly into the banking system by the sellers then in that case deposits with banking system will increase by $350 billion.

Deposits with banking system are part of M1. So, increase in deposits with banking system will increase the M1 as well.

Thus, M1 will initially increase by $350 billion.

Hence, the correct answer is option 1

b) Total increase in reserves with banks = $350 billion

Reserve requirement = 10% or 0.10

Required reserves = Increase in reserves * Reserve requirement = $350 billion * 0.10 = $35 billion

Excess reserves = New reserves - Required reserves = $350 billion - $35 billion = $315 billion

Money multiplier = 1/Reserve Requirement = 1/0.10 = 10

Increase in lending capacity = Excess reserves * money multiplier = $315 billion * 10 = $3150 billion

Thus, the banking system's lending capacity will increase by $3150 billion.

(c) Investors tends to borrow more when interest rate falls as this reduces their real cost of borrowing.

Secondly, when money supply increases, interest rates tends to decrease.

So, interest rate must fall to induce investors to utilize this expanded lending capacity.

d) The lending capacity of banking system has increased by $3,150 billion. If investors utilize this lending capacity in full then investment in economy will increase by $3,150 billion. Investment is an component of aggregate demand.

So, before the effect of multiplier kicks in, aggregate demand will initially increase by $3,150 billion, if investors borrow and spend all the newly available credit.