Question

The Fed threw a lot of money at the financial crisis in 2008 to unfreeze credit markets and encourage economic activity. As part of its effort to keep the interest rateâ low, the Fed purchased government bonds worthâ $300 billion between March and September 2009. Byâ October, the Fed heldâ $770 billion in governmentâ securities, nearly double itsâ pre-crisis total. Before theâ crisis, the Fed held mainly governmentâ securities, which it used to control the quantity of money in the economy. Now government securities make up justâ 35% of theâ Fed's balance sheet.

Required:
If the Fed purchased the government securities on the openâ market, explain why the purchase ofâ $300 billion of government securities would influence the interest rate.

Answer 1

The actions of the Fed in 2009 are consistent with an expansionary monetary policy and this policy reduces or keeps interest rates low.

When the Fed bought that many government securities, they flooded the economy with $300 billion in cash. This cash would make its way into the pockets of people and into their bank accounts as savings.

With that many savings, banks would have much more money to loan out to people and as a result of this increase in the supply of loanable funds, interest would fall in order to entice people to borrow more of these excess funds.