Question

1). Explain the Fed's three tools of monetary policy and how each is used to change the money supply. Does each tool affect the monetary base or the money multiplier?

2). Suppose everything else equal; a) the Central Bank raises the reserve requirement to 20 percent, b) the currency deposit ratio rises to 60 percent. Which development, a) or b) will affect the money multiplier more? Why?

3). Suppose the Central Bank of Turkey starts to pay interest on reserves. Under what circumstances this would affect the short term policy interest rate?

Answer 1

Solution:

1) The three tools of monetary policy are the following:

1. Open Market Operations
2. Discount Rate
3. Reserve Ratios (Requirements)

These tools are used to change the money supply in the economy.

1. Open Market Operations: It refers to the purchase and sale of government securities by the central bank. When the central bank wants to increase the supply of money they purchase government securities and creates liquidity in the market. On the other hand, sell government securities to reduce the supply of money in the economy.
2. Discount Rate: It refers to the interest rate which the central bank charges from commercial banks for borrowing loans from the central bank. If the rate is low, it will result in more commercial lending and this will increase the supply of money in the economy. On the other hand, higher rates will result in less fund for commercial lending and this will reduce the supply of money in the economy.
3. Reserve Ratios (Requirements): The reserve ratios are the legal requirement which commercial banks have to maintain with the central bank. Higher the ratios lower will be the supply of money in the economy and lower the ratios more will be the supply of money in the economy.

2) The currency deposit ratio rises to 60 percent will affect the money multiplier more. As higher ratio will reduce the ability of the bank to lend more and this will further affect the process of money creation.