Answer: The Fed's actions ripple through the economy. For instance, if the Fed tries to fight a recession, the Fed lowers the federal funds rate by buying securities in open market operations. The Fed pays for its purchases of securities by increasing banks' reserves, which lowers the federal funds rate. In addition, the increase in banks' reserves increases the quantity of money. The interest rate falls and thereby consumption expenditure and investment increase. In addition, the value of the dollar on the foreign exchange market falls as fewer foreign investors demand dollars to purchase assets in the United States. As a result, net exports increase. All these changes in expenditure lead to a multiplier effect that increases aggregate demand, thereby raising the price level and increasing real GDP.
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ReplyDeleteThe Fed's actions ripple through the economy. For instance, if the Fed tries to fight a recession, the Fed lowers the federal funds rate by buying securities in open market operations. The Fed pays for its purchases of securities by increasing banks' reserves, which lowers the federal funds rate. In addition, the increase in banks' reserves increases the quantity of money. The interest rate falls and thereby consumption expenditure and investment increase. In addition, the value of the dollar on the foreign exchange market falls as fewer foreign investors demand dollars to purchase assets in the United States. As a result, net exports increase. All these changes in expenditure lead to a multiplier effect that increases aggregate demand, thereby raising the price level and increasing real GDP.