Question

Specify which types of OMO is conducted for expansionary monetary policy, and explain the end result of this to the real economy, including levels of investment.

Answer 1

Expansionary monetary policy increases money supply, so the relevant OMO is open market purchase of government securities.

Open market purchase of government securities increases total reserves in the banking system, which increases the supply of reserves in federal funds market and leads to higher credit lending and therefore, causes an increase in money supply.

Since higher supply of reserves decreases federal funds rate, market interest rate falls, leading to an increase in investment and increase in consumption that is funded by borrowing. Higher consumption and investment increases aggregate demand, shifting AD curve rightward, increasing price level, increasing real GDP and decreasing unemployment.