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Federal government targeting money stock

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1. (a) Suppose the Fed has already decided that it wants to target the money stock.

(1) Will the Fed come closer to its target by setting the interest rate at a given level, or will it do better by fixing the money supply through open market operations? In your analysis, think in terms of the Fed's horizon from one Open Market Committee meeting to another -- about 4-6 weeks. This analysis involves the relative stability of money demand and the money multiplier. Consider two alternative cases: (1) a stable demand for money allows the Fed to set an interest rate that ensures it will come close to the target money supply; and (2) an unstable demand for money.

(2) In your analysis, discuss the proposition that the Fed may need to target interest rates in the short run in order to meet its target money stock while in the long run it may need to pay attention to interest rates and bank reserves and currency growth. NOTE: Shifts in money demand may reveal themselves first in movements in interest rates -- and if the Fed wants to stabilize the economy, it should respond to shifts in money demand.

(b) Within the same general context, discuss why the Fed, if it wants to stabilize and grow GDP and employment, has chosen a quantitative easing (QE) approach by growing bank reserves though purchases of Treasury securities and mortgage-backed securities and the monetary base rather than an interest rate policy (presently QE2 policy is to purchase $85 billion per month of Treasury and mortgage-backed securities? Why has the European Central Bank (EU) and Japan followed the same policy? How does this process work to stimulate economic growth? Has the QE policy since 2011 worked to increase GDP growth and employment?

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The impact of Federal Reserve actions on money stock is discussed step-by-step in this solution. The response also has the sources used.

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1.(a) The Fed will not come closer to its target by setting the interest rate at a given level. It will do better by fixing the money supply through open market transactions. The standard monetary policy for the Fed is to lower the interest rates. Lower interest rates are used by the central bank to stimulate the economy. However, the difficulty arises when the standard policy cannot be implemented. Currently the Fed Reserve rate is close to zero and monetary policy cannot lower interest rates. In these circumstances, the Open Market Committee has no option but to go in for open market transactions. The Federal Reserve has the option of changing the level of bank reserves. A lowering of bank reserves can lead to a liquidity crisis of the type that happened when the Lehman Brothers crisis happened in September 2008. The size of the multiplier depends on the percent of deposits that banks are required to hold as reserves. It is money used to create more money. Increasing the multiplier may have the effect of destabilizing the banking sector. The point is that lowering the reserve requirement has its limitations and lowering the reserve requirement beyond a point can lead to destabilization of the monetary system. A stable demand for money that allows the Fed to set an interest rate that ensures it will come close to the target money supply is not an option. The Federal Open Market Committee has announced that it is likely to maintain the federal funds rate close to zero at least through 2015. Lowering the interest rate is not an option. The interest ...

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