Question

At the end of 2008, the United States Federal Reserve and Treasury Department announced programs to purchase various assets, such as mortgage-backed securities or even commercial bills, from banks. Briefly explain how such actions will affect the money supply. (Please provide the definition of M1 and explain if the above action will directly affect M1.)

Answer 1

Ans) M1 supply of money include the coins and currency in circulation. Which consists of  coins and bills that circultes in an economy which are not to be helded by the US treasury or at the federal bank or the in the bank vaults.The other component is the demand deposits that is the deposits of the people in the banking system.That are to be returned if the depositor want his money back.The financial crisis occurred in the year of 2008. That was due to the subprime mortagage crisis.The lending was done without the proper procedure of Know your Client or KYC norms.Due to the sub prime mortgage crisis there was a huge impact on the liquidity and the money supply.There was a great reputational risk on the banking system , and the level of confidence of the depositors in the banking system declined hence the Federal reserve adopted the open market operations to ensure liquidity and financial well being of the banking system.By providing the short term loans to the member bank which are colleteralised by the government securities with lower interest rate to increase the liquidity or money supply in the economy.The impact of this policy is such that the fund crisis of the entity is resolved through the above open market operations as they have enough liquidity to avoid the sale of Mortagage backed securities at a lowe rate and a big loss also the fed purchased the MBS to help lower mortagage rates and the collapse of mortagage market.Secondly the fed response will stimulate the economic activities and intern increase the money supply as well as the improvement in the overall financial heath as the increase of governmental spending will stimulate the commercial paper market.The above action will directly abd indirectly affect the M1 supply as due to the Open market operation the liquidity increases and with lower interest rate the loans will be available to the investors which will encourage availibility of funds and indirectly the trust in banks encourages more deposits hence there will be more M1 supply of money as demand deposit is the part of M1 supply along with currency and coins in circulation.