Recently the Brazilian central bank decreased its target overnight interest rate. In doing so it is trying to decrease interest rates in the money market
(a) Explain why the central bank must be willing to increase the money supply to support lower interest rates in the money market.
(b) The central bank can change the money supply is through an open market operation. In this case, should it buy bonds from, or sell bonds to, the banking system? How would the transaction affect the amount of reserves in the banking system? How does the change in reserves lead to the required change in the money supply (measured by deposits in the banking system)?
(c) Suppose we could treat the Brazilian economy as a closed one. What effect will the results of the policy have on investment, on aggregate expenditure? Include diagrams in your answer.
(d) Similar to Canada, Brazil is an open economy. What additional effect will the policy have on aggregate expenditure?
(e) How will aggregate demand be affected, whether we treat the economy as closed or open?
(f) Under what conditions would this be a stabilizing policy? Explain.