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stabilizing economic struggle

Economics
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determine the key steps that the Federal Reserve should take to help stabilize the economy. Next, explain how your proposed steps will affect money supply, interest rates, inflation rate, aggregate demand, and output.

Jun 9th, 2015

The Fed's Monetary Policy Tools

Now that we have examined how adding or reducing reserves in the banking system affects the money supply, let us consider the Fed's role in changing the money supply. Given our discussion, it should come as no surprise that the Fed changes the money supply by altering the level of bank reserves.

Remember the definition of the monetary base and the determination of the money supply:

  • the monetary base equals all reserves held by banks and all currency in circulation.
  • Money supply = (Monetary base) x (Money multiplier)

and

  • Change in the Money supply = (Change in the Monetary base) x (Money multiplier).

So let us focus our attention on how the Fed uses its policy tools. The Fed will alter the monetary base and thus change the money supply by a multiple of that amount.

The Fed uses monetary policy to influence economic activity. But the Fed does not have direct control over the pace of economic growth. Rather, it uses policy tools to accomplish this task. The chain of events that we will discuss in this section work as follows:

  1. The Fed uses one (or more) of its policy tools:
    1. Open market operations, which we will emphasize,
    2. Changes in the reserve requirement, and
    3. Changes in the discount rate.
  2. Open market operations and changes in the reserve requirement change bank reserves and the monetary base.
  3. Changes in the monetary base interact with the money multiplier to change the money supply.
  4. With changes in the money supply (along with Fed changes in the discount rate), the Fed targets interest rates.
  5. Changes in interest rates influence borrowing by businesses and consumers and thus change aggregate demand.
  6. As borrowing activity responds to changing interest rates, the Fed's goal is to influence economic activity (the growth rate of GDP).

Open Market Operations

The Fed's most important and widely used policy tool is open market operations. Remember the reserve requirement, which necessitates that banks keep 10% of the value of existing deposits on reserve with the Fed. This gives the Fed tremendous amounts of money with which to engage in financial transactions. Open market operations involve the buying and selling of government debt (Treasury Bills, Notes, and Bonds) by the Fed. The Fed makes these debt transactions with banks in order to alter total reserves in the banking system.

At this point, you may be scratching your head. The banks keep required reserves with the Fed. The Fed pays no interest to the banks on these reserves. And in some cases, the Fed then uses these reserves to buy bonds from banks, with the banks' own money? Yes.

Let us consider a specific example. Assume the Fed wants to use open market operations to increase bank reserves. Note that banks use a portion of customer deposits (liabilities) to buy assets in the form of federal government-issued debt. To increase bank reserves, the Fed buys some of the government bonds from banks. For example, if the Fed buys $10 million in bonds from a bank, the bank's reserves increase by $10 million, money which the bank will desire to loan out. The $10 million increase in bank reserves yields an equivalent increase in the monetary base.

Finding itself with $10 million in additional reserves from the sale of bonds to the Fed, the bank will rapidly put the money to work earning interest. By creating an additional $10 million in loans, the recipients of the loans will spend the money on goods and services. And through the multiplier process, when the bank makes loans, the money supply will increase by a multiple of the $10 million. The money supply will increase by an amount equal to the change in the money base ($10 million) times the money multiplier. If the reserve requirement is 10% and the money multiplier equals 10 (1/.10), the potential increase in the money supply will equal $100 million ($10 million x 10).

We assume that the businesses and individuals that borrow money from the bank do so with the intention of spending that money. Furthermore, as these businesses and individuals buy goods and services this creates income for businesses, employees, and other individuals. The majority of this income finds its way back into the banking system in the form of deposits.

To summarize thus far:

  1. The Fed buys bonds from banks.
  2. Bank reserves and the monetary base increase.
  3. Banks don't want money sitting in their vaults, earning zero return, so they attempt to loan out the money.
  4. To attract borrowers, banks lower the interest rates that they charge.
  5. The businesses and individuals who borrow the money from the banks spend it on goods and services.
  6. These expenditures create incomes that are deposited into the banking system.
  7. The money supply increases by a greater amount than the original Fed purchase of bonds because of the money multiplier.
  8. Increases in investment activity by businesses will increase aggregate demand and the growth rate of GDP.


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