Answer to Question #226518 in Macroeconomics for hafsa

Question

In the text we describe the effect of an open market purchase by the fed.

a.   Define an open market scale by the fed

b.   Show the impact of an open market sale on the interest rate and output. Show both the immediate and the long-term impacts.

Answer 1

a.      The handling of an open market sale is the polar opposite of that of an open market acquisition. Central banks sell their bonds in the open market in return for money, resulting in a decrease in the money supply. A central bank's open market sale is a contractionary monetary policy tool for reducing money supply in the market

b.     An open market sale causes leftward shift in LM curve, which causes increase in interest rate and fall in output. It is shown in the below diagram:

As shown in the diagram above, a leftward shift in the LM curve results in poorer output when the interest rate is high. Both immediate and long-run transmission mechanisms are employed to demonstrate the total effect. A decrease in money supply causes portfolio disequilibrium, and as a result, consumers invest less in bonds, bond prices fall, and interest rates rise. An increase in the interest rate causes a decrease in investment, a decrease in AD, and a decrease in Y. As a result of the decrease in income, there is a decrease in transaction demand for money and an increase in speculative demand for money. Increase in speculative demand cause fall in interest rate to E1. In summary, interest rises faster than the rate of inflation at first, but then levels off and reaches the i1 point at E1 equilibrium.

Both open market sale and open market buy are monetary policy measures used by central banks. When monetary policy is expansionary, open market purchases are made, and when monetary policy is contractionary, open market sales are made.