Question

Suppose you read in the newspaper that all last week the Fed conducted open market purchases and that on Tuesday of last week it lowered the discount rate. What would you say the Fed is trying to do?

Short answer

The Federal Reserve is attempting to stimulate the economy by increasing the money supply, which lowers interest rates, encouraging spending and investment.

Step-by-step solution

Analysis of open market purchases

Firstly, examine the concept of open market purchases. These are purchases of government bonds by the Federal Reserve. By doing so, the Fed effectively pumps money into the economy as it provides institutions and individuals with cash in exchange for their bonds.

Analysis of lowering the discount rate

Next, consider the action of lowering the discount rate. The discount rate is what banks have to pay when they borrow from the Federal Reserve. So, by lowering this rate, borrowing becomes cheaper. Cheaper loans encourage banks to lend more to the public, thus injecting more money into the economy.

Concluding the Fed’s actions

By combining both actions taken by the Fed - open market purchases and lowering the discount rate - it can be deduced that the Fed is trying to increase the money supply in the economy. An increase in money supply tends to lower interest rates, thereby encouraging businesses and individuals to invest and spend more. This kick-starts the economy and leads to increased economic activity.