Given the current situation—recession—the central bank will employ an open market operation in order to stimulate the economy. Show on a diagram and explain what will happen in the money market as a result of the central bank’s intervention.

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A recession in the economy indicates increased savings, low spending, and low output. In order to counter these conditions, the Federal Reserve may attempt open market operations to increase money supply. This is generally accomplished through lowering the prime rate (the rate at which banks can borrow money), selling off government bonds, or both.

As can be seen on the diagram, a move in interest rate from 6% to 5% moves the demand for money along the liquidity demand curve (Ld). This causes a new equilibrium in the money supply at M1, as players get rid of excess savings through spending.

By purchasing bonds, the Federal Reserve is able to more directly increase the money supply. This type of purchase causes a shift in the supply of money from M0 to M1. This increase in supply of money results in excess savings, again pushing interest rates down. Lower rates are associated with increased spending, thus having a counter-recessionary effect.

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