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bank reserves, the money supply, interest rates, and aggregate demand

Suppose that you are a member of the Board of Governors of the Federal Reserve System. The economy is experiencing a sharp and prolonged inflationary trend. What changes in: 1- reserve ratio, 2- discount rate, 3- open-market operations would you recommend? Explain in each case how the change you advocate would affect commercial bank reserves, the money supply, interest rates, and aggregate demand.

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The Federal Reserve controls the three tools of monetary policy--open market operations, the discount rate, and reserve requirements. The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. The Federal Reserve Act of 1913 gave the Federal Reserve responsibility for setting monetary policy.

The Board of Governors of the Federal Reserve System is responsible for the discount rate and reserve requirements, and the Federal Open Market Committee is responsible for open market operations. Using the three tools the Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and in this way alters the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.

The central bank influences interest rates by expanding or contracting base money, which consists of currency in ...

Solution Summary

Three tools of monetary policy are summed.