Final Essay Example | Topics and Well Written Essays - 750 words - 3

Final - Essay Example It impacts the reserves held by banks and other institutions to lend money to corporations and households. On a larger scale, it affects the supply of reserves in the banking system, and thus the interest rates and overall growth in the economy. a) If central bank sells government bond, it takes money in exchange for the bonds. This reduces the reserves of private sector banks, and their capacity to make loans to households and corporations and thus cause money growth to decline through money multiplier mechanism. The central bank usually targets a certain level of bank reserves or a particular interest rate for these reserves. OMO allows Fed to affect the supply of reserve balances in the banking system and therefore influence short term interest rates. Given that Fed sold 1 million dollars’ worth of government securities, and that the money multiplier is 5. The reserves of banks and lending institutions to go down by $1 million, this money could have been used to give out lo ans worth $5 million (Amount X Multiplier). This is part of Fed’s tightened the monetary policy. The graph below shows how a change in the supply of money influences interest rates. The supply curve of money shows the quantity of money supplied, with all other things remaining constant. As the quantity of reserves is determined by the Fed’s monetary policy, the supply curve of money is assumed to be vertical line. ... The components of GDP include: Consumption (C) Investment (I) Government Expenditure (G) Net exports (X - M) These components are easily influenced by changes in interest rates. When interest rates are high, people do not want to borrow money through loans as it is more expensive to repay. This reduces the demand for most of the products such as cars, new houses or house renovation, large appliances, luxury goods etc. which causes the overall consumption in the economy to fall. Businesses also avoid raising money for expansion or start up through loans because the interest rates are higher. Similar is the case for government borrowing. As interest rates increase, the foreign investment will tend to rise because foreigners will get a large return on their investment. This drives up the demand for dollar and causes exchange rate to rise. As exchange rates surge, our imports will become cheaper and their demand will rise; exports will be more expensive for foreigners, so their demand wi ll fall. The graph below depicts how a change in the aggregate demand will impact price level and real GDP of the economy. The graph above shows a shift in aggregate demand curve from AD to AD’, it shows the impact on price level as prices have reduced from P to P’; the real GDP in the economy has fallen from Y to Y’. As we know that the demand for labor is a derived demand, that is, it is required only when a higher quantity of other goods is required. If the aggregate demand for goods and services in the economy goes down, a lower quantity of labor will be required to produce these goods. People who are willing and able to work will not find jobs,