The Federal Reserve's Open Market Committee (FOMC) sets monetary policy, and orders the buying and selling of Treasury securities in order to change the money supply.
How does this impact on economic activity? In three ways:
Buying Treasury securities increases the money supply. The Fed will issue a check to the seller. If the seller is a bank, this is a direct addition to bank reserves. If the seller is a private person or corporation, they will deposit the check to their account -- and banks will add this to their reserves and begin the money multiplier process.
But buying Treasury securities will also tend to REDUCE THE RATE OF INTEREST . The logic is simple:
The tricky point in the above is the inverse relation between bond prices and the rate of interest . To understand it, you must understand the distinction between the face value of a bond, which is the amount paid by the issuer of a bond when it matures, and the price of the bond, the amount paid by the purchaser of a bond when it is sold at auction. Some bonds carry as well coupon payments or annual payments; the math is a bit simpler with zero-coupon bonds such as Treasury bills, and we will stick to those for our examples.
A Treasury bill is a zero-coupon bond with a maturity date 3,6,9 or 12 months after its issue at the weekly Treasury auction , at which the bills are sold to the highest bidder. The T-bill promises to pay $10,000 at maturity; what price are bidders willing to pay for it right now?
Certainly $10,000 a year from now is worth less than $10,000 now, so bidders will pay something less than $10,000 -- let's say the winning bid is $9,500. The rate of interest on the zero coupon bond can be calucated as the percentage change in the bond's value from purchase to maturity:
or 5.26 percent.
If the price of the bond went up to $9,600, the net gain to the purchaser when the bond matured would be only $400 (rather than $500), and the effective interest rate would be:
or 4.17 percent.
Federal Reserve bond purchases will drive up the price of bonds, and hence will tend to drive down the interest rate.
The expansionary effect of an open-market purchase comes partly from the fact that interest rates may drop -- if interest rates drop, it is cheaper to borrow money for investment, and more real investment will take place.
The quantity theory suggests that expanding the money supply will increase the price level; a continuous expansion of the money supply will cause a continuous increase in the price level -- that is, ongoing inflation.
Unexpected inflation harms lenders and benefits borrowers -- the reason this may result in an economic stimulus is that borrowers are often entrepreneurs, who have borrowed money to launch a new business venture. Their new business will be more profitable than they expected, since they can raise the price of their output in line with inflation, and the real value of their loan repayments are less than expected. They may very well want to expand their business still more.
Wesley C. Mitchell argued that the American Civil War inflation
(Lincoln issued "greenbacks " to pay for the war, and demonstrated
the quantity theory quite nicely) did have such a result. In particular,
Mitchell argued that wages lagged behind the inflation, resulting in additional
profit for entrepreneurs -- and that these profits financed the industrialization of the United States after the war.
Once the rate of inflation becomes "expected", the Fisher effect guarantees that any stimulus the monetary expansion provided will be reversed. Since inflation has other costs (see Mankiw's text for a discussion of menu costs and shoe leather costs), and since there is the possibility that people may overestimate inflation, the chances are that the long-run impact of a monetary expansion will be negative.
This does not necessarily mean that any monetary expansion is a bad idea -- there may be short run benefits as well as longer run costs; if you are in enough trouble in the short run, the long run costs may be worth bearing.