(Transcript of audio with descriptions. Transcript includes narrator headings and description headings of the visual content)
(Speaker)
This chapter introduces you to monetary policy and how the Federal Reserve used monetary policy to change the interest rate. In this problem, you are going to use the liquidity preference model to show the effects of an open market operation. Part a is asking how to explain how the federal reserve lowers the interest rate in the short run. To answer this question, we are going to use our basic money demand and money supply graph.
(Description)
Because of the economic slowdown associated with the 2007 - 2009 recession, the Federal Open Market Committee of the Federal Reserve, between September 18, 2007 and December 16, 2008, lowered the federal funds rate in a series of steps from a high of 5.25 percent to a rate between zero and 0.25 percent. The idea was to provide a boost to the economy by increasing aggregate demand. Use the liquidity preference model to explain how the Federal Open Market Committee lowers the interest rate in the short run. On the Figure there are graphs of money supply and demand. Horizontal axis corresponds to the quantity of money. Vertical axis corresponds to interest rate (r). Two straight lines are plotted with demand line passing through points on two axes at the same distance from the origin and supply line parallel to the interest rate axis at M1. Lines intersect at point (M1,r1).
(Speaker)
Recall the Federal Reserve controls the money supply line making it vertical. To lower the interest rate, the Federal Reserve conducts an open market purchase. They purchase US Treasury bills from commercial banks. In exchange for selling US Treasury bills, commercial banks receive excess reserves. Commercial banks lend out these reserves which increases the money supply.
(Description)
To lower the interest rate, the Federal Reserve purchases government bonds which increases the money supply.
(Speaker)
Once the reserves are lent out, the money creation process takes over, resulting in a bigger increase in the money supply. We can show the increase in the money supply as a rightward shift of the line. At the initial interest rate, r1, there will be an excess supply of money. In order to create more loans, banks must lower the interest rate. The interest rate will fall to r2.
(Description)
On the Figure there are graphs of money supply and demand. Two straight lines are plotted with demand line passing through points on two axes at the same distance from the origin and supply line parallel to the interest rate axis at M1. Lines intersect at point (M1,r1). Additional vertical line on the right side of the original supply line is plotted. New intersection point for supply and demand lines is (M2,r2). Arrows indicate the right shift of the money supply line.