Question

12. Explain how the Fed uses open market operations to provide monetary stimulus to the macro economy. Explain how the Fed expects this monetary stimulus to affect aggregate demand (AD)? What are some of the reasons that such monetary stimulus might prove futile?

Answer 1

When the economy is in recession, the Federal Reserve uses expansionary monetary policy to stimulate economic growth. The key objective of the Federal Reserve is to expand the money supply and push interest rates lower in the economy. To achieve this objective, the Federal Reserve can use the following tools -

1. Purchase bonds from the open market

2. Lower discount rate

3. Lower the reserve requirement

The most commonly used tool by the Federal Reserve is to purchase bonds from the open market. When the Fed pursues open market operations, it buys bonds from banks and financial institutions, which are infused with liquidity. As liquidity in the banking system increases, the overnight federal fund rate declines. This is the rate at which banks borrow from one another on an overnight basis.

When federal fund rates decline on ample liquidity in the banking system, the banks pass the benefit to consumers and businesses and interest rate decline in the economy. At lower interest rates, consumers are more willing to pursue leveraged consumption spending and this triggers consumption growth in the economy. Higher consumption spending also translates into higher investment spending at lower cost of money. Therefore, a mix of higher consumption and investment spending shifts the aggregate demand curve to the right and GDP increases along with an increase in price levels.

One of the major factor that can make the monetary stimulus futile is the banking system. A good example is the financial crisis of 2009. The federal reserve pursued expansionary monetary policy and pushed federal fund rates to near zero levels. However, the baking system became risk averse and tightened lending standards. At the same time, consumers who were already over leveraged did not prefer further leverage in uncertain economic conditions. Therefore, even at low interest rates, higher consumption spending was not triggered in the economy.