Question

GENERAL BUSINESS COURSE QUESTION:

Joe and Jill were talking about the role played by the Federal Reserve System in the United States. Joe seemed to be quite well informed about the functions and activities of our central bank. "You see, Jill, the Fed is the main guardian of our nation's economic stability," Joe declared. "In America, we don't want inflation and we don't want recession. To stretch the situation just a bit, we are frightened, absolutely terrified, by thoughts of hyperinflation and depression. So, the Fed maintains the right to alter the situation and protect us from these two monsters. And you ask, how they do that? The answer is the discount rate. That is the device that the Federal Reserve System uses to keep us safe."

Jill was enjoying listening to her friend explain it all. Joe continued, "Now the discount rate is the interest rate that the twelve Federal Reserve Banks around the country charge their member banks on a loan. So, when the discount rate goes up, all interest rates tend to go up. And, happy to say, when interest rates go up all over America, this tends to slow down any inflationary tendencies." Jill asked, "Does the Fed have other tools for stopping inflation?" "No," said Joe.

3) If tomorrow morning the Fed ordered that the reserve requirements for all banks would be raised significantly, what effect would that have on the money supply?

Answer 1

Increasing or decreasing the reserve requirements of banks is an important macroeconomic tool used by the Federal Reserve System in the United States to control money supply in the economy. Reserve requirements or reserve ratio is the ratio of money that a bank should be held in the bank itself, that can not be used for lending purposes. Inflation and availability of money for spending are directly related. Raising reserve requirements for banks will help the Federal Reserve to reduce the liquidity and thereby contain inflationary tendency in the economy. If the reserve ratio is increased significantly that will automatically reduce the capacity of banks in lending money as they want to keep more money as a reserve. It, in fact, reduces the availability of money for spending activities in the market and that is ultimately helpful in containing inflation.

please give Up-vote if you like the answer. Thank you.