Question

The Federal Reserve and the money supply

Suppose the money supply (as measured by checkable deposits) is currently $400 billion. The required reserve ratio is 20%. Banks hold $80 billion in reserves, so there are no excess reserves. The Federal Reserve ("the Fed") wants to decrease the money supply by $35 billion, to $365 billion. It could do this through open-market operations or by changing the required reserve ratio. Assume for this question that you can use the oversimplified money multiplier formula. If the Fed wants to decrease the money supply using open-market operations, it shouldsell $7 billion worth of U.S. government bonds. If the Fed wants to decrease the money supply by adjusting the required reserve ratio, it shouldincrease the required reserve ratio.

Answer 1

1. Sell $7 billion worth of U.S. government bonds

2. Increase the required reserve ratio.

Step-by-step explanation:

1. If the Fed wants to change the money supply in the economy, it can use the Money Multiplier to determine how much is it has to put in or take out of the economy to increase/decrease the Money supply to a certain level. The Money Multiplier is a figure that shows how much the money supply will increase/ decrease by as a result of an additional dollar put into or removed from the economy.

Formula is;

= 1/ Reserve Ratio

= 1 / 20%

= 5

Federal Reserve wants to decrease supply by $35 billion.

$35 billion = Amount of Bonds to sell * Multiplier

$35 billion = Amount of Bonds to sell * 5

Amount of Bonds to sell = 35/5

Amount of Bonds to sell = $7 billion worth of bonds

2. If the Fed wants instead to use the required reserve ratio to reduce money supply then it should increase the ratio. This way banks will have to keep more money in reserve instead of giving it out as loans. This reduced lending in the economy will lead to less money being created and hence a reduced money supply.