✏️ Classic OMO problem

Be able to do this:

According to 📰 The open market desk, on Jan 02, 2020, the Fed Purchased $53.8M of Treasuries from NatWest Markets:

Trade date	Settlement date (T+1)	Transaction category	Face Value (in $M)	Issuer	Coupon & Maturity	CUSIP Security ID Number	Price per $100 of face value	Accrued interest (in $)	Par Amount *Price/100 + Accrued	Total amount (in $M)	Counterparty
Jan 02 2020	Jan 03 2020	Purchase	50.0	TSY	02.875 07/31/25	912828Y79	106.28906250	609,375.00	53.75	53.8	NatWest Markets Securities Inc.

In an ample reserve regime like we have today, the Fed does OMOs as quantitive easing or just to ensure that reseves remain ample. Reserves had gotten tight in late 2019, so this open market operation was likely done simply to add more reserves into the market.

However, lets suppose that the Fed did a similar open market operation back in 2005, when reserves were limited.

❔ Suppose that the Fed purchased $53.8 million of treasuries in 2005. Once the complete money multiplier process has played out, what will the change in the money supply be? Assume that R=10% and E=2.5%. Is this expansionary or contractionary monetary policy? What will happen to interest rates, unemployment, and the economy?

✔ Click here to view answer

$$\text{Initial Deposit (aka the initial Change in Reserves)} = +\$53.8M$$$$\begin{aligned} \Delta \text{Total Deposits} &= \text{Initial Change in Reserves} \times \frac{1}{(\text{R}+\text{E})} \\ &= \$53.8\text{M} \times \frac{1}{12.5\%} \\ &= \$430.4\text{M} \end{aligned}$$

$430.4M of deposits will be created after the money multiplier process plays out.

$\Delta \text{MS} = \Delta \text{Total Deposits} + \Delta \text{Cash Held By Public} = \$430.4\text{M} + \$0 = \$430.4\text{M}$

The money multiplier process will play out, as the lent money is spent and deposited.
This is Expansionary monetary policy because the money supply increased. Interest rates will fall, causing the economy to expand and unemployment to fall. (On an exam, he would likely want you to explain this with a diagram, so read the question carefully.)

✏️ Redo the problem, but with the Fed had selling the bonds instead of purchased them.

[Hint: you’ll do the same math, but with $\text{Initial Change in Reserves} = -\$50M$]