Question

ASSUME: you are a member of the Board of Governors of the Federal Reserve System. The economy is experiencing a sharp and prolonged inflationary trend. State the appropriate change (increase, decrease, buy bonds, sell bonds) in monetary policy, using the following quantitative monetary tools, you would recommend to achieve the legal mandate to the Federal Reserve of maintaining full employment and stable prices. State in each case how the change you advocate would affect commercial bank reserves, the money supply, interest rates, and aggregate demand (increase or decrease).

Answer Question # 5

(Ai) state the recommended change in the Reserve Ratio (increase or decrease)- increase

(Aii) state the resulting change (increase or decrease) in:

bank reserves-

Money supply- decrease

Interest rates-

Aggregate demand-

(Bi) state the recommended change in the discount rate (increase or decrease)-

(Bii) state the resulting change (increase or decrease) in:

bank reserves-

Money supply-

Interest rates-

Aggregate demand-

(Ci) state the recommended change in open market operations (buy or sell bonds)-

(Cii) state the resulting change (increase or decrease) in:

bank reserves-

Money supply-

Interest rates-

Aggregate demand-

Answer 1

A)The reserve ratio is the total amount of funds a bank must have on hand each night. It is a percentage of the bank's deposits. The nation's central bank sets the percentage rate.

--> An increase in reserve ratio will increase the reserves held by commercial banks leading to reduced money supply in the economy,which further raises interest rates and thus reducing aggregate demand in the economy.

-->A decrease in reserve ratio will decrease the reserves held by commercial banks leading to increased money supply in the economy,which further lowers interest rates and thus increasing aggregate demand in the economy.

B) Discount rate is the interest rate that the Federal Reserve charges banks for short term loans.

-->Raising the discount rate makes it less profitable for banks to lend due to reduced reserves, so they raise the interest rates they charge on loans, and this discourages borrowing and slows or stops the growth of the money supply.This also reduces aggregate demand.

--> Lowering the discount rate makes it more profitable for banks to lend due to increased reserves, so they lower the interest rates they charge on loans, and this encourages borrowing and Increase the growth of the money supply.This also increases aggregate demand.

C)Open market operations (OMO) refers to when the Federal Reserve purchases and sells U.S. Treasury securities on the open market in order to regulate the supply of money that is on reserve in U.S. banks, and therefore available to loan out to businesses and consumers. It purchases Treasury securities to increase the supply of money and sells them to reduce the supply of money.

-->When fed purchases government securities,it will lead to increased reserves with banks and increased money supply in the economy.this also reduces interest rates and Increases aggregate demand.

--> When fed sells government securities,it will lead to reduced reserves with banks and decreased money supply in the economy.this also increases interest rates and decreases aggregate demand.