(15pts) Banks and the Money Supply (5pts) Suppose the Fed reduces the discount r
ID: 1112916 • Letter: #
Question
(15pts) Banks and the Money Supply
(5pts) Suppose the Fed reduces the discount rate. How will this affect the monetary base, the money multiplier, and the money supply?
(5pts) Suppose that the economy enters a recession, banks are failing due to poor investments/loans, and consumer confidence is falling. How will this recession affect the currency-deposit ratio, the reserve-deposit ratio, the money multiplier, and the money supply?
(5pts) Considering the scenario in part (c), discuss at least one policy the central bank can undertake in order to keep the money supply stable
Explanation / Answer
1. As the discount rate falls this will mean that the money supply in the economy will rise as people will want to borrow more as the interest rate is lower. This will mean that the monetary base will increase. Also as the currency in circulation will increase as the money supply rises the money multiplier will increase as the money supply rises.
2. As consumer confidence is falling this will mean that consumption levels will fall and the aggregate demand will fall. This will cause the currency deposit ratio to fall as currency in circulation falls.The reserve deposit will rise as more money is kept in banks and banks hold greater reserves. The money multiplier naturally will fall as the currency in circulation falls. Money supply falls.
3. In a situation of falling money supply the Fed can resort to an open market purchase of bonds. This will take away bonds from the economy and release money supply into the economy and hence keep the money supply constant. An open market purchase is thus needed.
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