Question

1. What is the FOMC (Federal Open Market Committee)? What tools does it have available to alter the monetary base (MB)? Explain the workings of each tool.

2. How is the monetary base (MB) connected to the money supply (MS)? Be explicit on the connection.

Answer 1

1. What is the FOMC (Federal Open Market Committee)?

During times of recession or inflation, the government of a country needs to take corrective action to ensure that the economy is stabilized. In modern economic countries this is generally done through the use of a Federal Bank which may be known as different names in different countries

The federal bank of a country regulates the overall supply of money in the country’s economy i.e. which is held by normal residents of the country or by banks that create money by keeping it in circulation. This money which is present in the economy is also known as Monetary Base of a Country.

The Federal Bank in the United States was created in 1913 to correct the economy and since then has served as one of the key organizations which has helped to have a sustainable economy.

The FOMC or the Federal Open Market Committee is aligned with buying and selling of securities as needed in the economy and is an important wing of the Federal Bank of the country.

The FOMC meets several times in a year and usually has up to 14 members. The decision making happens over a democratic voting system respectively.

What tools does it have available to alter the monetary base (MB)? Explain the workings of each tool.

The Federal Open Market's operations can generally be categorized into two kinds of tools these are permanent and temporary and can be taken simultaneously or as the economy of the country desires.

Permanent Tools:-

These tools are used by the organization during periods of high volatility and are usually in the sense of buying or selling of Treasury securities.

Purchase of Securities

When the FOMC purchases securities, it infuses money into the country by raising the Monetary Base. This is primarily done during a time of deep recession when the banks have a cash crunch. In such a situation money which gets pumped into the system due to the purchase of securities by the FOMC helps in providing relief to the industries by making sure that the banks have enough flow of money to grant as loans.

Sale of Securities

Another permanent tool is selling securities which are purchased by commercial banks. As a result of which the overall money supply reduces and inflation when occurs in the country can be checked as well.

Temporary Tools:-

Temporary Tools are those which are implemented during times of transition in the economy these come in the form of two major techniques:-

These are of two types

Repurchase agreements which are sold in the market and bought at a later stage. This allows for adjusting the economy for a certain period of time. Commercial banks buy the agreement and sell them to the Federal Bank after the stipulated time. This allows for a check on inflation during transition.

Reverse Repo Agreements do just the opposite they are bought by the federal bank and then later sold back thus allowing temporary flow of money in the economy.

2. How is the monetary base (MB) connected to the money supply (MS)? Be explicit on the connection.

The Monetary Base serves as a guide allowing commercial banks to give out loans or refrain from the same. The Monetary Base reflects the total amount of money in the country which is either in circulation or generally held by commercial banks.

An increase in the Monetary Base changes the overall supply of money in the economy. At any point of time, a result of a crunch in the Monetary Base causes the banks to have limited resources for giving out as loans and on the other hand an expansionary policy would allow this base to be increased thus allowing banks to give out loans much easier with the increased flow of money thus increasing the overall supply of money in the economy.

Thus the changes in the Monetary Base Directly reflect on the supply of money and are positively correlated. If banks have higher flows of money they can grant loans easier thus causing a shift in the supply and similarly the reverse can take place in a country respectively.

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