How Would A Decrease In The Reserve Requirement Ratio, Combined With An Open Market Purchase Of Government Securities, Affect The Money Supply And Subsequently Impact The Interest Rates On Commercial Loans, Assuming The Economy Is Operating At Or Near Full Employment And The Inflation Rate Is Currently At 2%?

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The combined effect of decreasing the reserve requirement ratio and conducting open market purchases of government securities would lead to an increase in the money supply. This expansionary monetary policy would put downward pressure on interest rates, making commercial loans more affordable.

Step-by-Step Explanation:

  1. Decrease in Reserve Requirement Ratio:

    • Banks are required to hold a smaller percentage of deposits in reserves.
    • This frees up more funds for lending, increasing the money supply.

  2. Open Market Purchases:

    • The central bank buys government securities from banks, injecting more liquidity into the banking system.
    • Banks now have more reserves, enabling them to extend more loans, further increasing the money supply.

  3. Impact on Interest Rates:

    • Increased money supply reduces the demand for loans, leading to lower interest rates.
    • Lower interest rates make borrowing cheaper, encouraging businesses and consumers to take loans.

  4. Economic Context:

    • With the economy near full employment and inflation at 2%, the central bank might aim to sustain growth or prevent potential economic cooling.
    • While increased money supply could risk inflation, current stable inflation suggests the policy aims to support economic stability without overheating.

Conclusion: These policies increase the money supply and lower interest rates on commercial loans, stimulating economic activity through cheaper borrowing, while carefully balancing against inflationary risks.