Question

The Federal Reserve System was established to provide a stable monetary system for the entire economy. The Federal Reserve Bank (the Fed) has three major tools to control the money supply: 1) reserve requirements, 2) discount window for loans to member banks, and 3) open market operations.

When the economy is in a recessionary mode, what will likely be the actions by the Federal Reserve using monetary policy? Suppose the Federal Reserve purchases a $100,000 bond from John Doe, who deposits the proceeds in the Manufacturer's National Bank; what will be the impact of this transaction on the supply of money?

How do each of the Fed's tools work? What is the fractional reserve system, and how does it work in relation to the Fed? Review the Federal Reserve System and how the Fed alters the monetary base to achieve the levels of money supply in the economy.    

Answer 1

The monetary policy followed by the Fed regulates money supply to stabilise the economy from both inflationary and recessionar pressures.For example suppose the Federal reserve purchases a 100,000 $ bond from John Doe,who deposits the proceeds in the National bank there willl be a multiple increase in money supply,that the bank can create credit out of this 100,000 $ keeping the required reserve.That is the fractional reserve system,that the commercial banks are regulated by the Fed to keep a fraction of their deposit liabilities.The minimum amount the banks are required to hold is determined by the central bank (the Federal reserve system in U.S.),and is called the reserve requirement or reserve ratio,banks even keep excess reserves.So the higher reserve ratios if regulated by the Fed over the commercial banks it controls the banks' ability to create money,and in turn controls money supply.

The Fed sets monetary policy by influencing the federal funds rate, the rate at which the banks charge each other for the inter bank lending of excess reserves.This rate is influenced by the Fed using its tools,namely open market operations,Discount rate and reserve requirements.During times of recession,when the demand in the economy is weak the monetary tools will be so designed to increase the money supply and thereby increasing the aggregate demand in the economy,and therefore the Fed would add more reserves with the banking system by reducing the fractional reserves,purchasing the bonds in the open market and reducing the discount rate.

Effects on the quantity of reserves that banks makes loans,influence the money supply and economy.Policy actions that add to the reserves encourage lending and reduce interest rates,and policy actions that absorb reserves reduces the money supply and control inflation.