Question

1. Describe how the money supply is measured in the United States and how banks, the public, and the Federal Reserve can influence it.

2. Explain what we want the Federal Reserve to be independent of, why that is important, and what parts of its structure help give it independence.

Answer 1

1. In USA the money supply is measured by M1 and M2 where

M1 = currency in circulation + checking deposits + traveler's check

M2 = M1 + savings + time deposits + money market mutual funds.

The Fed is the controller of the money supply in the economy. It has direct powers and tools to affect the money supply. Banks can influence the money supply by changing the interest rates they charge on loans and the interest rates they pay on deposits. The public can affect the money supply by determining and changing their demand for money which includes transaction demand for money, speculation demand for money and precautionary demand for money.

2. We want the FED to be independent of the government and its fiscal policy. It is important because there are many instances where the fiscal and monetary policies can contradict each other. This is due to difference in the objectives of the two institutions. The government has objective to increase GDP and income using fiscal policy whereas the FED's core objective is to control the inflation. So if the government goes for an expansionary policy to increase GDP which leads to inflationary pressures, the FED will have to implement a contractionary monetary policy to check the inflation which will lead to decrease in GDP. Hence, the contradiction.

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