Question

Suppose the Federal Reserve (Fed) decides the current money supply of $2.1 trillion is too low, and that an increase of $300

billion is necessary.
What tool can the Fed use to accomplish this increase? Assume the current reserve ratio is 0.05.
a. Sell government securities.
b. Increase the reserve ratio.
c. Increase the interest paid on bank reserves.
d. Buy government securities

Answer 1

The Fed can use the tool of buying government securities to increase the money supply by $300 billion. Here's how:

When the Fed buys government securities from banks, it pays for them by crediting the banks' reserve accounts with the Fed. This increases the amount of reserves that banks have available to lend out. Because the reserve ratio is 0.05, banks can lend out up to 20 times the amount of reserves they hold.

So, if the Fed buys $300 billion of government securities from banks, this increases the reserves held by banks by $300 billion. Banks can then lend out up to 20 times this amount, or $6 trillion. This increases the overall money supply by $300 billion in reserves plus $6 trillion in loans, for a total increase of $6.3 trillion.

Selling government securities would have the opposite effect, reducing the reserves available to banks and decreasing the money supply. Increasing the reserve ratio would also reduce the amount of lending and decrease the money supply.

Answer 2

To increase the money supply by $300 billion, the Federal Reserve can buy government securities using open-market operations, which is the correct method for injecting money directly into the economy.

Step-by-step explanation:

If the Federal Reserve decides the current money supply is too low and wants to increase it by $300 billion, it can use open-market operations. This is one of the basic tools the Fed uses to manage the nation's money supply. To do so, the Fed would proceed to buy government securities. This action injects money directly into the economy because the sellers of these securities now have more money in their accounts, which they can spend or deposit into banks, thereby increasing the money supply. It's important to note that selling government securities would rather decrease the money supply, increasing the reserve ratio would restrict banks' ability to lend and does not directly alter the money supply, and increasing the interest paid on reserves would encourage banks to hold onto their money, rather than lend it out, thus not increasing the money supply effectively.