This topic is chosen because it shows how the US Central Bank deal with their secession by using quantitative easing, which is closely related to monetary policy and how it affects the aggregate demand and aggregate supply. By using Economic Analysis: Monetary Policy: Objectives and Framework Central bank is a national bank that controls the quantity of money and banking services for its country’s government and commercial banks. Their responsibility is to stabilize currency, control inflation and maximize employment. Investigated, 2009) To achieve these goals, central banks uses three main policy tools, which is liquidity reserves ratio, open market operations government securities and also last resort loans. Monetary policy: Expansionary Monetary Policy Fed uses expansionary’ monetary policy like quantitative easing to curb recession. Quantitative easing is a monetary policy whereby a Central Bank injects more money into the economy by purchasing government or mortgages bonds with the new money that they have created (Economics Online, 2013).
Open Market Operations (MOM) is the purchase or sale of government securities by the central bank from or to a commercial bank or the public. Hence, when Fed runs out of options, they will use quantitative aging to boost the economy by increasing money supply into the market (politics. Co. UK, 2012). When Fed buys more bonds through quantitative easing, it injects more money into the economy, decreases the interest rates and causes the investments output to increase. Based on the figure 1, when Fed injects more money to the economy and interest rates is reduced from or to RL , a shortage will occur.
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So in order to maintain the interest rates as low as possible and overcome the shortage, Fed will buy bonds in the open market operation to increase money supply and this is going increase the bank excess reserves. Based on figure 2, when the money supply increases, the money supply curve will shift from MOOS to MIS . However, if the money supply shifts to MIS , a surplus will occur when the interest is still at or. When there is surplus, the banks have excess liquidity to buy bonds. Buying bonds will increase the money demanded for speculation, which causes point A to go down to point B.
This will cause the interest rate to fall from or to RL . In order to maintain a low interest, Fed has to increase money supply, which can be seen at figure 2 where the money demand is equal to the money supply at he equilibrium point, point B. Since there is more money in the market and the interest rates are lowered, more money will be lend out and cost of borrowing will decrease as well, which helps stimulate spending since it is easier to borrow money. This can be seen in Figure 3 where investment increases from 10 to II and this will eventually increase the Real GAP demanded.
Aggregate Demand and Aggregate Supply Aggregate demand is the total quantity of final goods and services produced domestically that business, government, consumers and foreigners plan to buy at a period of time. This quantity is the sum of AD=C+I+G+NIX. Aggregate supply curve is the relationship between quantity of real GAP supplied and the price level. The aggregate supply the amount of real GAP supplied which is the total quantity of goods and services that firms plan to produce during a given period (Investigated, 2009). Since people can purchase more comfortably, this will cause a greater demand for goods and services.
When investment increases, this will cause aggregate demand to increase as well. Hence, the increase of consumption and investment will cause the aggregate demand to increase. Based on figure 2, the aggregate demand curve to shift o the right from DAD to DAD. However, there is a shortage at POP, but because price is flexible, the shortage will be curbed. The shortage is curbed when point A moves to point B and point C moves to point B when there is increase in price which indicates the increase of revenue that causes the aggregate supply to increase as well.
Therefore, economy moves from point A to B where the recession is curbed and the economy settles to full employment at point B. One of the main reasons the Fed chose not to taper and continue on with the quantitative easing because unemployment rate has reduced from . 1% to 7. 3% (The Economist, 2013). Quantitative easing helps in increasing employment because aggregate demand and output are proportional. Hence, if AD increases, the output increases as well and this will require more labor work causing the demand for labor to increase (Essays. Mom, 2013). This will increase employment rate. Moreover, it helps to boost household wealth and increases the disposable income. Quantitative easing can increase income because workers can expect a raise when the economy is doing better. Since the economy is doing better and there is an increase in business expansion, there will be higher paying jobs. (Milliken, 2013). Therefore, the Fed wants to continue on with quantitative easing as it is increasing employment rate and boosting the household income.
Conclusion & Suggestion: In conclusion, the Fed managed to achieve their objectives through quantitative easing. However, quantitative easing is very risky and it may be ineffective after some time. The drawback of quantitative easing is inflation may occur because of the increase in money supply and the value of US dollar to drop. Hence, the Fed needs to implement quantitative easing ruefully with other policies to avoid severe side effects, as these long-term impacts will be very high.