Which sequence follows an open market purchase by the Fed?

• A. i↑ ⇒ I↓ ⇒ AE↓ ⇒ Y↓
• B. i↓ ⇒ I↑ ⇒ AE↑ ⇒ Y↑
• C. i↓ ⇒ I↓ ⇒ AE↓ ⇒ Y↓
• D. i↑ ⇒ I↑ ⇒ AE↓ ⇒ Y↑

Answer: (B)

Open market purchases inject liquidity into the banking system, increasing the money supply. With more money in the economy, the cost of borrowing falls, so the short-term interest rate goes down. Because investment is sensitive to interest rates, lower rates stimulate investment. The rise in investment boosts aggregate expenditure (AE = C + I + G + NX), and higher AE leads to a higher level of output in the short run. So the sequence is: a fall in the interest rate, then an increase in investment, then an increase in aggregate expenditure, and finally an increase in output.