Suppose the Fed decided to sell $400 billion worth of government securities in the open market (assume all payments are are directly deposited into or withdrawn from the banking system)

Solution:

a.)

Correct answer = Increase by $400 billion

Reason:

When fed purchase $400 billion worth of securities and deposit the amount in bank account, The deposit at the bank increase by $400 billion. Since deposit at bank is a component of M1, with purchase of securties M1 increases by $400 billion.

b.)

Correct answer = $1600 billion

Reason :

Suppose the reserve requirement is 20%. The bank will keep reserves equal to $80 billion [400*20% = $80]

Since the deposit at bank increases its reserves by $400 billion, the amount of excess reserves with bank will be $320 billion [400-80=320]

The value of money multiplier is

multiplier = 1/ reserve requirement

= 1/20%

= 5

Increase in lending capacity = excess reserves * money multipiler

= $320*5

= $1600billion.

c)

Correct answer = fall

Reason:

Investment borrow more at lower interest rate due to lower borrowing cost at low interest rate.

d)

Correct answer = increase by $1600billion

Reason:

If investors borrow and spend all the newly available credit of $1600 billion, then the investment increase by $1600 billion. Since investment is component demand increase by $1600 billion.

e)

Correct answer = Recession

Reason:

Fed pursue open market policy to stimulate demand. During recession period, the aggregate demand falls, thus fed pursue open market policy during recession.