Question

explain two ways by which the central bank can decrease the money supply. why is the effect of the central bank actions on bank reserves less exact than the effect on the monetary base ?

Answer 1

Central Bank can decrease the money supply by increasing reserve ratios and also through selling government bonds to public. If government take decision to increase the reserve ratios then the commercial bank will have less for advances and loans. If government sell government bonds and securities through open market operations then the public will purchase those securities and bonds and as a result people will have less money in hand. These two policy of increasing reserve ratios and selling government bonds and securities through open market operations can reduce the money supply.

When central bank take action on bank reserve then it doesn't directly affect the money supply but it affects through different channels but when there will be change in monetary base it directly affects the money supply. Because the monetary base are the most liquid form of money in the economy. Fed has less control on reserve but they have more control on changing monetary by selling government bonds and securities which has directly effect on money supply.