Navigation
Tracing the path from a change in the money supply to a change in real GDP.
How does a single computer click at the Federal Reserve in Washington D.C. eventually lead to a construction worker in your town getting a new job?
When the Federal Reserve wants to stimulate the economy, it initiates Expansionary Monetary Policy by purchasing government bonds. This increases the Money Supply (), which lowers the nominal interest rate (). But why does this matter for growth? The key lies in the Investment Demand Curve (). Businesses constantly evaluate potential projects (like building a new factory). They only proceed if the expected rate of return exceeds the interest rate. As falls, more projects become profitable, leading to an increase in Investment Spending ().
1. A tech company wants to build a $\$106\%7\%5\%5\% < 6\%\ million.
Quick Check
If the interest rate rises, what happens to the quantity of investment demanded, and why?
Answer
The quantity of investment demanded decreases because the cost of borrowing now exceeds the expected return on fewer projects.
Monetary policy doesn't stop at the water's edge. When US interest rates () fall, foreign investors seek higher returns elsewhere. They sell their US assets, which requires selling US Dollars (). This increase in the supply of dollars on the foreign exchange market causes the dollar to depreciate (lose value). A 'weaker' dollar makes US goods cheaper for foreigners and foreign goods more expensive for Americans. Consequently, Exports () rise and Imports () fall, causing Net Exports () to increase.
1. US interest rates drop from to , while European rates stay at . 2. Investors move funds from New York to Frankfurt to get the higher return. 3. They sell to buy Euros (). The depreciates. 4. A US-made tractor that cost EUR now only costs EUR for a French farmer. US exports increase.
Quick Check
How does a decrease in the US interest rate affect the value of the dollar and net exports?
Answer
The dollar depreciates (weakens), which causes net exports to increase because US goods become cheaper for foreign buyers.
Trace the impact of a Fed Open Market Sale of bonds: 1. Fed sells bonds Money Supply () decreases. 2. Interest rates () increase. 3. Investment () decreases (higher borrowing costs). 4. Foreigners demand to buy high-interest US bonds appreciates. 5. Net Exports () decrease (US goods are now expensive). 6. shifts left Real GDP decreases and inflation slows.
Which of the following best describes the 'Investment Demand Curve'?
If the Federal Reserve buys bonds on the open market, what is the most likely effect on the international value of the dollar and net exports?
Expansionary monetary policy increases Aggregate Demand by increasing both Investment () and Net Exports ().
Review Tomorrow
In 24 hours, try to sketch the 5-step chain of events starting from a Fed bond purchase and ending with a change in Real GDP.
Practice Activity
Look up the current 'Federal Funds Rate.' If the Fed raised this rate tomorrow, would you expect the US Dollar to get stronger or weaker against the Euro? Why?