Long Answer (50 points total): 1. (20 Points) Suppose the economy is experiencin

Question

Long Answer (50 points total): 1. (20 Points) Suppose the economy is experiencing a recessionary gap. The Federal Reserve decides to use open market operations in order to increase the money supply. Their goal is to increase the money supply by $100 million. In order to increase the money supply, should the Fed buy or sell bonds a. If the required reserve ratio is 0.20, what is the total amount of bonds they should buy/sell in order to reach their goal? (What sh b. market transaction amount be?). Using both words as well as graphs, explain how the e above would help reduce the recessionary gap? (Be sure to expla this would impact the money market and interest rates, and hov that would impact aggregate demand and output. You will need graphs, one for the money market and one AD-AS model). You abel all markets, axis, curves, equilibriums, and outcome get full cred.

Explanation / Answer

Question 1

(a)

In the given case, Federal Reserve wants to increase the money supply.

When Federal Reserve wants to increase the money supply, it purchases or buys bonds.

This is because when Federal Reserves buys bonds, reserves with banks increases which enable banks to make more loans thereby creating more money and increasing money supply.

So, in order to increase the money supply, Fed should buy bonds.

(b)

Desired increase in money supply = $100 million

Required reserve ratio = 0.20

Money Multiplier = 1/Required Reserve Ratio = 1/0.20 = 5

Calculate the total amount of bonds Fed should buy -

Amount of bonds Fed should buy = Desired increase in money supply/Money Multiplier = $100 million/5 = $20 million

The Fed should buy bonds worth $20 million in order to reach their goal.

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