Consider the classical open-economy macroeconomic model. Explain how a Federal Reserve action such as buying bonds impacts an economy that is operating under the following assumptions: exchange rates are flexible but wages and prices are sticky, there is perfect capital mobility and the economy is already at full employment. Be clear how it impacts GDP, unemployment, inflation, and the exchange rate. Provide the necessary equations to support your answer and diagrams.

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Asked Dec 2, 2019
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Consider the classical open-economy macroeconomic model. Explain how a Federal Reserve action such as buying bonds impacts an economy that is operating under the following assumptions: exchange rates are flexible but wages and prices are sticky, there is perfect capital mobility and the economy is already at full employment. Be clear how it impacts GDP, unemployment, inflation, and the exchange rate. Provide the necessary equations to support your answer and diagrams.

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Expert Answer

Step 1

The purchase of the bonds is carried out by the Fed and this is a part of the Federal open Market Operations. The decision to sell the bonds or to purchase the bonds is taken based on the condition of the economy. When the bonds are sold in the economy, it is a part of the contractionary monetary policy and when it is purchased, it is a part of the expansionary monetary policy.

Step 2

In this case, the Fed is purchasing the bonds from the market. This means that the Fed is providing money to those who holds the bonds to transfer the ownership of bonds back to Fed. This increases the money supply in the economy. The money supply would increase in the economy and this is why it is known as a part of the expansionary monetary policy. Under the open economy, an increase in the money supply means that the interest rate in the economy will fall as the supply of money increases.

Step 3

The capital in the open economy is like a butterfly. It will be mobile and will easily transfer from one economy to another when the interest rate in the later is higher. Thus, the increased money supply and the associated decline in the interest rate will result in the outflow of capital from the econom...

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