By affecting AD e.g. U.S. is in recession ****Refer to Graph 14Suppose US is in recession at Pt. A, y < y barFed’s objective is to shift AD back to AD, How? Fed controls the MS and therefore it
Money Market (M1) Md – demand for M1 for transactions Assume: HH’s hold a portfolio of assets that include only : - Money (M1) earns zero interest - Bonds – loan interest Bonds – are financial securities sold by corporations and governments to help finance their operations e.g. US Treasury bonds finance the government deficit Deficit = (Tax Revenues – Government Expenditures) < 0 Investors buy bonds because they earn interest annually. e.g. 1 year bond for $1000 at 0.50%. When bond matures at end of year investor receives: Principle $1000 + Interest .005 x 100 5 1005 ****Refer to Graph 15 The opportunity cost of holding M1 is the interest … could earn on a bond. As interest rates increase from 1% to 5%, MD decreases from $1000 to $900 ****Refer to Graph 16 MS is controlled by the Fed. It is set at the amount necessary, e.g. $950 for y = y bar ****Refer to Graph 17 4/11 : ****Refer to Graph 18 [money market] How does the Fed increase MS? - Engineers open market purchase (OMP) Treasury bonds from investors in the bond market Investors receive checks from the fed Investors will deposit their checks in their deposit accounts at local bank and a multiplier process occurs (see last class notes) MS shifts right How does the Fed decrease MS?
AD = C + I + G + NX (AD, C, and I increase) AD shifts back to the right - See Fig. 1 4/16 : US in recession Fed engineers omP => decreased i => increased C, increased I OMP => Expansion of deposits, i.e. multiplier process kicks Change in D = m x change in TR Change in TR = OMP = $10 billion rr = 0.10 $100 billion = 1/.10 x 10 billion OMP to bring US out of recession is AKA: - Expansionary/simulative monetary policy Transmission Mechanism – the mechanism that links monetary policy actions to the financial system and ultimately inflation (price level) and real GDP
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