Question

   The Market(Economy) is in a recession. The Federal Reserve start an open market operation. Explain in detail how economy will respond.

1. Explain how the Open Market Operation will impact the real economy,
2. Explain the Open Market Operation's impact on asset allocations and the prices of securities;
3. Explain each step of the adjustment of this process
4. Graph the process.     

Answer 1

OMO is a monetary tool used by the central bank of a country to increase or decrease the supply of money in the economy by sale and purchase of government securities and bonds.So it affects the money supply in the economy.When the Federal reserve buys bond from the bank , the bank gets money which it can lend.The money supply will increase.Thus When central bank purchase securities the reserves of commercial bank swill increase which will be used to lend .Secondly it will increase the prices of government securities and reduce interest rate,decreased interest rate will give a boost to business.Opposite will happen when the central bank sells securities.

OMO can be used to stabilize the prices of government securities . Asset allocation is the process of deciding where to engage money to work. Asset allocation is an investment strategy.Asset allocation is most important decision that investors make .With thousands of stocks, bonds and mutual funds to choose from , selecting the right one is done by OMO. OMO purchases by RBI will guide investors.

When the central bank of a country buys government bonds the economy is in recession with unemployment.Buying of bonds increases money supply and interest rate decreases.The decreased interest rates cause consumption and investment to increase and hence aggregate demand increases.Increased demand causes GDP to rise.

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