Which sequence follows an open market purchase by the Fed?

Which sequence follows an open market purchase by the Fed?

• A. i↑ ⇒ I↓ ⇒ AE↓ ⇒ Y↓
• B. i↓ ⇒ I↑ ⇒ AE↑ ⇒ Y↑
• C. i↓ ⇒ I↓ ⇒ AE↓ ⇒ Y↓
• D. i↑ ⇒ I↑ ⇒ AE↓ ⇒ Y↑

Answer: (B)

Open market purchases inject liquidity into the banking system, increasing the money supply. With more money in the economy, the cost of borrowing falls, so the short-term interest rate goes down. Because investment is sensitive to interest rates, lower rates stimulate investment. The rise in investment boosts aggregate expenditure (AE = C + I + G + NX), and higher AE leads to a higher level of output in the short run. So the sequence is: a fall in the interest rate, then an increase in investment, then an increase in aggregate expenditure, and finally an increase in output.

Open market purchases inject liquidity into the banking system, increasing the money supply. With more money in the economy, the cost of borrowing falls, so the short-term interest rate goes down. Because investment is sensitive to interest rates, lower rates stimulate investment. The rise in investment boosts aggregate expenditure (AE = C + I + G + NX), and higher AE leads to a higher level of output in the short run. So the sequence is: a fall in the interest rate, then an increase in investment, then an increase in aggregate expenditure, and finally an increase in output.