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Unformatted text preview: Effectiveness of Monetary Policy Interest Rate Q of Money M D Interest Rate Interest Rate M D M D Q of Money Q of Money M S * M S * M S * M S M S M S i * i ' i * i ** i '' Q of Investment Interest Rate I = I - bi Investment I i* i** Liquidity Trap 1. 2. 3. 4. In order for open market operations to actually affect the economy, a sequence of events has to happen: 1. The Federal Reserve has to be able to increase the money supply 2. The increase in the money supply has to decrease interest rates 3. The decrease in interest rates has to increase spending With regard to the first problem, if people lose confidence in banks and start holding money in the form of currency instead, the money multiplier will drop. The money supply is equal to the monetary base times the money multiplier. During the Great Depression, the money multiplier dropped in half and because the FED did not offset that drop with a corresponding increase in the monetary base, the money supply also dropped in half....
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- Winter '11
- Monetary Policy