Let’s assume the Fed’s required reserve ratio is 15% and the Fed wants to expand the...

Let’s assume the Fed’s required reserve ratio is 15% and the Fed wants to expand the money supply by $20B. How would the Fed do it? Show your work. What problems might the Fed run into?

Expert Solution

To increase money supply, Fed can take following measures:

1. Open market purchase of federal securities, and/or

2. Decrease required reserve ratio below 15%, and/or

3. Decrease existing bank rate (discount rate).

Out of these three tools, we can calculate the exact value of option (1).

Required open market purchase ($ billion) = Increase in money supply x Required reserve ratio

= 20 x 15%

= 3

However, fed might not succeed due to following reasons:

1. Fed cannot precisely estimate the proportion of currency held by public that is not deposited in banks. The higher this proportion, the lower the money multiplier and the lower the incraese in money supply.

2. Fed cannot precisely estimate the proportion of total reserves held by commercial that is not lent to public. The higher this proportion, the lower the money multiplier and the lower the incraese in money supply.

Rahul Sunny answered 2 years ago

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