Assume the central bank engages in aggressive open market purchases in an effort

Question

Assume the central bank engages in aggressive open market purchases in an effort to stimulate the domestic economy. The nation has flexible exchange rates and the central bank does not intervene in the foreign exchange markets.

a) Show the shift in the supply or demand for RLF by inserting a new curve. Insert arrows to show the change in R and RLF.

b) The open market purchases (increase or decrease) the supply of RLF which causes R to (rise or fall).

c) Lower real interest rate encourages households to borrow to finance purchases, so the C (rises or falls). Similarly, lower R encourages firms to purchase new capital equipment and I (rises or falls).

Explanation / Answer

a) Open market purchases will release more currency in the market as the central bank will be buying securities from the market. Supply of RLF will increase, thus supply curve will shift rightwards. R will decrease.

b) Open market purchases increase the supply of RLF which decreases R.

c) Lower R will increase the money in hands of public, thus increasing the consumption.

Similarly, Investment will rise as firms will purchase new capital.

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