Final answer:
The Federal Reserve's purchase of U.S. Treasury bonds from the public leads to an expansion of the money supply and lowers interest rates. This expansionary monetary policy encourages lending, investment, and can boost exports by lowering the value of the dollar, effectively stimulating the economy during a TFP shock caused by a pandemic.
Step-by-step explanation:
When the Federal Reserve buys a large amount of U.S. Treasury bonds from the public, it effectively conducts an expansionary monetary policy. This action increases the money supply because the Fed uses new money to pay for these bonds, thereby injecting additional funds into the banking system. As a response to a negative Total Factor Productivity (TFP) shock, like that caused by a coronavirus pandemic, this measure aims to stabilize the economy and support financial markets.
The purchase of bonds raises the price of bonds in the bond market, which correlates with a decrease in interest rates. Lower interest rates make borrowing more attractive, which can stimulate investment and consumption. Federal Reserve asset purchases, especially on a large scale, lead to an increase in bank reserves, encouraging banks to lend more, thus further increasing the availability of money. In addition, reduced short-term interest rates can devalue the U.S. dollar in global markets, promoting a boost in exports.
An expansion in money supply leads to several economic effects: it can stimulate economic activity, counteract the negative impact of the TFP shock, lower the exchange rate, and potentially close any recessionary gap by shifting the aggregate demand curve to the right.