When pursuing expansionary monetary policy, the Federal Reserve (the Fed) aims to stimulate economic activity and increase the money supply. One tool the Fed uses is open market operations, which involve buying government bonds in the open market.
To determine the amount of bonds to buy in order to address an economy operating at 10 billion less than the long-run equilibrium, the Fed follows the following process:
1. Assess the Current Economic Situation: The Fed examines various economic indicators such as GDP, inflation rates, employment levels, and interest rates to gauge the state of the economy and identify any deviations from the long-run equilibrium.
2. Set Monetary Policy Goals: Based on their analysis, the Fed determines its monetary policy goals. In this case, the goal is expansionary monetary policy to stimulate the economy and increase the money supply.
3. Determine the Desired Change in the Money Supply: The Fed calculates the desired change in the money supply necessary to close the 10 billion-dollar gap and bring the economy back to the long-run equilibrium level.
4. Calculate the Necessary Bond Purchases: The next step is to calculate the amount of bonds the Fed needs to buy to achieve the desired change in the money supply. Since the reserve requirement is given as 25%, the Fed multiplies the desired change in the money supply by the inverse of the reserve requirement. This ensures that the increase in reserves resulting from bond purchases will have the desired effect on the money supply.
For example, if the desired change in the money supply is X dollars, the formula to calculate the amount of bonds to buy would be:
Amount of Bonds to Buy = X / (1 - reserve requirement)
Using the given reserve requirement of 25% (or 0.25), the formula becomes:
Amount of Bonds to Buy = X / (1 - 0.25)
5. Execute Open Market Operations: Once the Fed has determined the amount of bonds to buy, it carries out open market operations by purchasing government bonds from market participants, such as banks and financial institutions. These bond purchases inject money into the banking system, increasing the reserves held by banks and expanding the money supply.
By adjusting the money supply, the Fed influences interest rates, borrowing costs, and overall economic activity, aiming to bring the economy closer to the long-run equilibrium level.
It's important to note that the specific calculations and actions taken by the Fed may vary based on the prevailing economic conditions, policy objectives, and other factors.