Question

Suppose that you are a member of the Board of Governors of the Federal Reserve System. The economy is experiencing a sharp and prolonged inflationary trend. What changes in (a) the reserve ratio, (b) the discount rate, and (c) open-market operations would you recommend?

Explain in each case how the change you advocate would affect commercial bank reserves, the money supply, interest rates, and aggregate demand.

Answer 1

To counteract the inflationary situation a contractionary monetary policy should be taken, that is reduction in the money supply.

a). Reserve requirements- Every commercial banks have to keep a certain percentage of their deposits as reserves with the central bank of the nation. The remaining fund is the excess reserves of the commercial banks, the banks lend out of the excess reserves. So to decrease the inflation the reserve requirement has to be increased, when the Fed increases the reserve requirement the excess reserve of the commercial banks would fall and they have now less money to lend and that is a decrease in the money supply so the interest rate will increase. The cost of borrowing is the interest rate so when the interest rate increases the business borrow less and invest less and the aggregate demand would decrease.

b). The discount rate is the rate at which the central bank lends to the commercial banks, so when the Fed increases the discount rates the borrowing for the commercial banks become expensive so they borrow less , and this decreases the excess reserves of the banks. So this is decrease in the money supply , increase in the interest rate and decrease in the aggregate demand. ( Previously mentioned in the first question).

c). If the Fed use the open market operations they would sell the government owned securities, the open market operation is the process of selling and buying the government owned securities by the central banks. When the Fed use this tool they are directly influencing the money supply in the economy.

To reduce the money supply the Fed should sell the securities , so the squeeze out the money supply from the public. When they sell the securities it decreases the banks reserves, the people withdraw their money from the bank to purchase the securities. So this should decrease the money supply and when the money supply decreases the interest rate increases and the aggregate demand would fall.