Question

9) Explain the 4 methods that the Federal Reserve uses to manage money supply in the U.S. economy.   (10pts)

10)   Explain the 3 Dow Jones Averages. How is the Dow Jones Industrial Average calculated daily? Explain why the Dow Jones Industrial Average is important to investors in the U.S. and around the world.       (10pts)

Answer 1

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• changing reserve requirements - the reserve ratio is the ratio of deposits that banks must hold with the Fed. By increasing (decreasing) this ratio, the Fed can decrease (increase) the money supply. With an increased (decreased) ratio, banks would be required to hold more (less) funds with the Fed, thereby decreasing (increasing) the funds available for lending.
• changing discount rate - discount rate is the interest charged by the Fed on funds lent to banks. By increasing (or decreasing) the discount rate, the Fed can decrease (or increase) the money supply. With an increased (decreased) rate, banks would have more (less) funds available for lending.
• open market operations - Securities such as T-Bonds and T-bills are issued by the Fed to decrease money supply. These securities which are already issued can be bought back by the Fed to increase money supply
• interest on reserves - banks may hold reserves with the Fed in excess of the required reserve ratio. The Fed pays interest to banks on these reserves. By lowering the rate, the Fed can incentivize banks to lend more, thereby increasing money supply. This is because with a lower rate, banks would have an opportunity cost as they could earn more interest by lending out funds rather than holding excess reserves with the Fed. By increasing the rate, the Fed can incentivize banks to hold more excess reserves, thereby decreasing the money supply.

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The 3 Dow Jones Averages are :

• Dow Jones Industrial Average is an index that is based on the value of 30 large, publicly traded companies belonging to various sectors. It is an indicator of the stock market value for the entire economy, representing various important sectors.
• Dow Jones Transportation Average is an index that is based on stock prices of 20 companies in the transportation sector - airlines, trucking, transportation services, railroads etc.
• Dow Jones Utility Average is an index that is based on stock prices of 15 companies in the utility sector - energy, water, natural gas etc.

The DJIA is a price-weighted index, and not a market-capitalization weighted index. The value of DJIA each day is the sum of the prices of all 30 stocks in the index, divided by a Dow Divisor. The Dow Divisor is published daily by the Wall Street Journal.

The DJIA is important to investors in the US and around the world because :

• It represents 30 of the largest companies in the US
• The US is the worlds largest economy
• It is a diversified index representing all the important sectors
• It is widely followed as in indicator of the health of the US economy
• A large number of funds in the US and around the world use the DJIA as a benchmark
• historical data is available for a very long time