Question

What happens to the money supply and the economy when the following monetary policy actions are taken:

1. Reserve Requirements are increased?
2. Reserve Requirements are decreased?
3. The Fed sells bonds? (also called quantitative tightening)
4. The Fed buys bonds? (also called quantitative easing)
5. Discount rate increases?
6. Discount rate decreases?

Answer 1

Reserve requirements are increased ie when a larger share of the deposits is kept as reserve and lesser is Lent out. In such a case , less money would be created by the money multiplier system and hence economy would have less of money supply.

In case of decreased reserve requirement, less deposit is kept in the banks and more is lent out this means that lending and other economic activities and increasing. This increases the money supply in the economy.

Fed sells bonds : This tool is used when the Fed wants to reduce the money supply in the economy. By selling bonds ,the money is being withdrawn from the economy. This leads to a decline in aggregate demand and economic activities.

Buying bonds: Fed buys bonds when it wants to increase the money supply. By buying the bonds, it is releasing the money in the economy, thereby increasing the money supply.

Discount rate increases : discount rate is the rate at which the Fed lends to member banks . If the discount rate is higher , then the banks would want to borrow less from the central bank and would keep more reserves. This means that less wpuld be Lent and money supply would reduce.

A decrease in Fed discount rate would mean that the banks are able to borrow at a lesser rate from the central bank and hence would keep less reserve(excess reserve). This would increase the money supply.

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