Question

1. During "normal times" the Federal Reserve pursues open market operations to affect the money supply and interest rates in the economy. For instance, during normal times, if the FED wanted to reduce short-term interest rates, it would buy short-term Treasury securities from the public. The FED's purchase of securities allows it to inject liquidity (money) to the financial system.

In contrast, during "exceptional times", the FED may pursue "unconventional" monetary policy to affect interest rates. During the implementation of the second quantitative easing program (QE2, which started in late 2010 and ended in mid 2011), the FED bought $600 billion dollars in Treasury bonds (long-term securities) during a period of eight months to reduce long-term interest rates. The FED expected that lower long-term interest rates would help the economy continue its recovery (the Great Recession ended in June 2009).

Explain using at least FOUR LINES, why (massive) purchases of long-term securities may reduce long-term interest rates.

Answer 1

The main tool that Fed uses to influence interest rates in the economy is buying and selling of government bonds. It decides whether to increase or decrease the rate of interest in the economy depending on whether it aims to increase or decrease overall demand for goods and services. When the policymakers decide to lower the rate of interest in the economy, then Fed buys government bonds. This purchase of government bonds by the Fed will increase the price of bonds and since price of bonds and interest rate is negatively related, it will lower the interest rate on these bonds. This will help in increasing investment and thus increasing overall aggregate demand in the economy. Thus, it can be stated in the end that massive purchases of long term securities may reduce long term interest rates in the economy and thus stimulate the economy.