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Effects of open-market transactions by the Fed

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1. Suppose the Federal Reserve sells government securities from its existing holdings to the financial sector and the non-bank public. Trace through the expected consequences of this secondary market action on the banking system - reserves, loanable and investable funds, and deposits; financial markets - bond and stock prices, and interest rates; inflationary pressures; credit-sensitive spending; and the general state of the economy as measured by real GDP (or real income) and unemployment.

2. Deficit spending at the Federal level involves increased government purchases or reduced net taxation with new bonds issued by the US Treasury. The Treasury must sell these new bonds to the public. The Federal Reserve can allow this without adjusting its own policies or, by combining this sale with open market purchases, it can, in effect, monetize the debt. What are the consequences for interest rates, spending financed by private borrowing, the money supply, the bond supply and inflation from each of these two options for dealing with new Treasury issues? In the second case for simplicity, assume the open market purchase by the Fed matches in value the auction and sale of new Treasury securities.

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Solution Summary

This solution explains the effects of the Federal Reserve's monetary policy, including the special case of when deficit spending by the government is balanced by an open-market purchase by the Fed.

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1.
The Fed sells securities to banks and the public in exchange for money.
Money is transferred from the economy to the Fed. The money supply of the economy decreases. Inflation decreases.
Banks' reserves decrease. Publicly held deposits, which were liquidated to buy the Fed's securities, decrease.
The supply of loanable and investable funds decreases. Interest rates, i.e. the price of investment funds, increase. ...

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