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 ration, (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

Answer 1

The government in order to ensure economic growth and stability influence the real variables like output, employment, price level etc. in an economy by adopting either monetary or fiscal policy. A monetary policy influences the variables by changing the money supply and a fiscal policy influences the variables by either changing taxes or the government spending.

There are many tools by which the monetary authority can influence the supply of money. These are;

• Reserve requirement
• Buying and selling of US security and other financial assets in open market.
• The volume of loans and discount rates
• The interest rate of reserve

(a) Reserve requirement:

The bank has to hold a portion of its transaction deposit as reserve with the Federal Reserve. The ratio at which it holds its reserve is called required reserve ratio. If the bank reserve at the Fed exceed the required reserve, the reserve over and above requires reserve is excess reserve (ER). Excess reserve does not earn any interest rate and the bank in order to eliminate excess reserve often makes out loans the excess reserve to companies and individuals. If the Fed increases its reserve requirement, the excess reserve of the bank will fall. They will make out fewer loans to the public and the supply of money will be reduced in the economy.

As supply of loan falls, the interest rate will increase. The higher interest rate will make investment expensive and investment will fall. This will decrease the aggregate demand in the market. The fall in aggregtae demand will decrease inflation.

(b) the discount rate

The discount rate is the rate at which the banks take loans from the Fed. The increase in the discount rate increases the Federal funds rate. The Federal funds rate is the rate at which the banks extend loans to other banks and financial institution in Federal funds market. The increase in the interest rate decreases the demand for loanable funds in the market. The amount of reserve decreases in the economy. The banks have fewer amount to loan out and supply of money decreases in the economy.

As supply of loan falls, the interest rate will increase. The higher interest rate will make investment expensive and investment will fall. This will decrease the aggregate demand in the market. The fall in aggregtae demand will decrease inflation.

(c) open-market operations

The open market operation is the most important method that the Fed uses to influence the supply of money. The Fed in order to decrease the supply of money, the FOMC tells the trading desk at the Federal Reserve Bank in New York to sell U.S. government securities from the public in the nation’s bond market. The buyers of the bond will likely to write a check against their deposit in the bank. The bank only has to hold the fraction of the new deposit as required reserve and the excess is the excess reserve, this decreases the excess reserve of the bank.

The bank loan out this excess reserve to a borrower and increase the borrower’s checking deposit at the Bank. In this case the bank fails to extend new loans and money supply falls in the economy. The initial decrease in money gets multiplied and decreases the money supply by the multiplier times of initial decrease in money supply.

The Federal Reserve Board of Governors and the FOMC are the prime decision maker for U.S. monetary policy. They decide whether to expand money supply to increase economic activity or to or to decrease money supply to decrease inflation. The Fed has three major methods by which to control the supply of money: it can engage in open market operation, change reserve requirement, or change its discount rate.

The most widely used tool is open market operation and changing discount rate. In this case to decrease supply of money and inflation the bank should engage in open market operation and changing discount rate.