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monetary policy

1. There are several tools the Fed uses to implement monetary policy.

A) Briefly describe these tools.

1) Reserve Requirement-requires banks to hold a fraction of deposits.
2) Discount Rate-the amount the Feds charge banks that borrow from them.
3) Open Market Operations- the buying and selling of U.S. government bonds.

B) Explain how the Fed would use each tool in order to increase the money supply.

2. Suppose the banking system has vault cash of $1,000 deposits at the Fed of $2,000, and demand deposits of $10,000.

A) If the reserve requirement is 20 percent, what is the maximum potential increase in the money supply given the banks' reserve position?

B) If the Fed now purchases $500 worth of government bonds from private bond dealers, what are excess reserves of the banking systems? Assume that the bond dealers deposit the $500 in demand deposits. How much can the banking system increase the money supply given the new reserve position?

3. Briefly describe the process of setting the federal budget in the United States. What is the time lag between the start of the process and the point at which the money is actually spent?

Solution Preview

1. There are several tools that the Fed uses to implement monetary policy. Of the three mentioned here the Fed primarily uses open market operations to conduct nation's monetary policy while central banks in developing countries rely primarily on reserve ratios. I will answer both A and B together in the following.

i. Reserve Requirements: Each commercial bank is required to keep a certain portion of all its demand deposits in form of cash or cash equivalent at the end of business each day. The reserve requirement is a primary determinant of the money multiplier. In the absence of currency drain if the required reserve ratio is R%, that is if banks are required to keep R% of total deposits as reserve then the money multiplier is given by

Money Multiplier = 1/R.

The Fed can alter the reserve requirement and thus change the money multiplier. Suppose initially the reserve ratio is 20% then the money multiplier is 1/20% = 5. If the Fed introduces $100 in the system then the net change in money supply is $500. Now if the Fed also reduces the reserve ratio to 10% then the multiplier becomes 10 and an introduction of $100 in the system increases money supply by $1000. Thus the Fed can lower the reserve ratio to increase money supply.

ii. Discount Rate: Discount rate is the rate at which the Fed lends money to commercial banks to meet overnight reserve requirements. The discount rate also helps determine the Federal Funds Rate, the rate at which commercial banks lend to other commercial banks to meet overnight reserve requirements, and the Federal Funds Rate is the main short-term rate that the market follows. If the Fed wants to increase money supply it can lower the Discount Rate, which in turn will lower the Federal Funds Rate, and this will propagate down to the ...

Solution Summary

Tools of monetary policy are explored.

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