Question

4. The Federal Reserve and the money supply

Suppose the money supply (as measured by checkable deposits) is currently $300 billion. The required reserve ratio is 25%. Banks hold $75 billion in reserves, so there are no excess reserves.

The Federal Reserve ("the Fed") wants to decrease the money supply by $32 billion, to $268 billion. It could do this through open-market operations or by changing the required reserve ratio. Assume for this question that you can use the oversimplified money multiplier formula.

If the Fed wants to decrease the money supply using open-market operations, it should billion worth of U.S. government bonds.

If the Fed wants to decrease the money supply by adjusting the required reserve ratio, it should the required reserve ratio.

Answer 1

Required reserve ratio = 25% = 0.25

=> Money multiplier = 1 / required reserve ratio

=> Money multiplier = 1 / 0.25

=> Money multiplier = 4

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Fed wants to decrease the money supply by $32 billion thorugh open market operation.

In order to decrease the money supply by $32 billion, Fed has to sell the sonds in open market.

Amount of bond to sell in open market = (Decrease in money supply / money multiplier)

=> Amount of bond to sell in open market = ($32 billion / 4)

=> Amount of bond to sell in open market = $8 billion

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Answer: If Fed wants to decrease the money supply using opent market operations, it should sell $8 billion worth of government bonds.

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Answer: If the Fed wants to decrease the money supply by adjusting the required reserve ratio, it should increase the required reserve ratio.

Explanation: An increase in required reserve ratio will make banks to keep more proportion of checkable deposit in reserve. As a result, they will have less proportion of deposit available to make loans. Less loans means less money supply creation.