Question

Using T-accounts, explain how the Federal Reserve can employ open market operations to increase the money supply. Then explain the impacts of that policy on interest rates, output (i.e., real GDP), and prices. Finally, explain what factors the Fed must take into consideration when determining how large the open market operations will have to be to achieve its economic objectives.

Answer 1

Open market operations can increase the money supply and lower interest rates, stimulating output and potentially increasing prices. Factors like desired change in money supply, prevailing interest rates, and the economy must be considered when determining operation size.

Explanation:Using T-accounts to Explain Open Market Operations

1. The Federal Reserve can employ open market operations to increase the money supply by buying U.S. Treasury bonds from commercial banks. This increases the reserves held by the banks, allowing them to lend more money.
2. When the money supply increases, it leads to a decrease in interest rates. This encourages borrowing and investment, which stimulates output and increases real GDP.
3. The increase in the money supply can also lead to an increase in prices, as more money chases the same amount of goods and services.
4. The size of the open market operations that the Fed must undertake to achieve its economic objectives depends on various factors, including the desired change in the money supply, the prevailing interest rates, and the state of the economy.