Question

1). The Fed can influence economic environment by regulating the money supply and interest rate. Discuss the main instruments that the Fed uses to achieve this. In your discussion give examples of how the Fed would address, a) inflationary gap, b) recessionary gap.

2). Critics of federal banking policy argue that deposits insurance is a key for banking failures. The banks enjoy a "heads I win, tails the government loses" proposition. Several possible reforms of deposit insurance have been suggested. For example, the limit on insured deposits can be increased, decreased, or eliminated. Do you think a change in deposit insurance would prevent bank failures? Discuss

Answer 1

Ans 1.)

The central bank of a country has full authority to change the money supply in the economy.

Similarly fed Can use various tools in order to change the money supply in the United States which are as follows:

(i) Discount rate:

It is the rate at which, fed lends money to the commercial banks.

As the Fed increases the discount rate, the banks take less loans as the coast of loans increases and this leads to the decreased reserves with the commercial banks which further leads to the decrease in the money supply in the economy.

When the fed decreases the discount rate, it leads to the increase in the money supply.

(ii) Open market operations:

Open market operations refers to the purchase and sale of government securities by the banks.

As the Fed sells government Bonds to the banks, it leads to decrease in the money supply in the economy and is thus referred to as contractionary monetary policy. And when the fed purchases the Government Bonds from the bank then it gives some amount in return which leads to the increase in the money supply and is referred to as the expansionary monetary policy.

(iii) Reserve ratio:

Reserve ratio is the proportion of the total deposits that the banks keep with themselves in the form of cash.

As the fed decreases the reserve ratio, it leads to the decrease in the reserves with banks and thus the money supply increases.

Inflationary gap is the economic situation which occurs when real GDP is more than the potential GDP.

It mainly occurs when the aggregate demand of the world economy increases substantially.

In this scenario government uses the contractionary monetary policy in order to bring down the money supply.

For example, the government uses the contractionary open market operations in which it sells the Government Bonds to the banks and gets money in return. The decrease in the money supply leads to increase in the interest rate which leads to the decline in the aggregate demand by the individuals. In this way, the government keeps using the policy until the real GDP becomes equal to potential GDP.

Recessionary gap occurs when the real GDP is less than the potential GDP. In this case, the government uses the expansionary monetary policy in order to bring the economy at equilibrium.

The government uses the expansionary monetary policy through open market operations and the increase in the money supply leads to the in the decline in the interest rates which further leads to the increase in the aggregate demand in the economy and the real GDP becomes equal to the potential GDP.