Answer to Question #226222 in Macroeconomics for Haru

Question

In the text we describe the effect of an open market purchase by the Fed.
a. Define an open market sale by the Fed.
b. Show the impact of an open market sale on the interest rate and output. Show both the Immediate- and the longer-term impacts.

Answer 1

Solution:

a.). An open market sale by the Fed refers to the sale of government bonds and other securities with the aim to reduce the money supply in the economy and increase interest rates.

This open market operation process is undertaken by the Fed when their goal is contractionary, that is when the economy is overburdened and inflation is at its peak. The Fed will sell bonds and other treasury securities to the banks, which takes money out of the financial systems by reducing their reserves, reducing the money supply. This will cause interest rates to increase thus discouraging individuals and businesses from investing and borrowing while encouraging them to save more. This will slow inflation and economic growth.

 

b.). An open market sale by the Fed will reduce the amount of reserves in the banking system which requires banks to decrease their outstanding loans hence reducing credit availability and ultimately the money supply. As a result, the interest rates will increase reducing investments and overall output in both the short-term and long-term.

This will shift the supply of loanable funds to the left from the original supply curve (S₀) to S₁, resulting in a new equilibrium of E₁ and a higher interest rate of i_1, and a decreased output of Y₁.

 

This is displayed by the below graph: