The Federal Reserve and the money supply Suppose the money supply (as measured b

Question

The Federal Reserve and the money supply Suppose the money supply (as measured by checkable deposits) is currently $650 billion. The required reserve ratio is 20%. Banks hold $130 billion in reserves, so there are no excess reserves. The Federal Reserve ("the Fed") wants to decrease the money supply by $10 billion, to $640 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 should (Buy/Sell) $______ billion worth of U.S. government bonds.

If the Fed wants to decrease the money supply by adjusting the required reserve ratio, it should (Decrease/Increase) the required reserve ratio.

Explanation / Answer

If required reserve ratio is 20 then money multiplier = (1/20) = 5

Change in money supply = change in the monetary Base * money multiplier

Open market operations changes bank reserves or, the monetary Base by the same amount. If Fed wants to decrease money supply by $10 billion(i.e. Ms= $10 billion) then it will sell bonds . The worth of bonds will be the change in monetary Base (i.e. Mb).

Therefore, from the given formula,

Mb= Ms / money multiplier

Or, Mb = $10 billion /5 = $2 billion

Therefore, Fed should sell bonds worth $2 billion.

•• if fed wants to decrease money supply by adjusting the required reserve ratio, then it should increase the required reserve ratio so that Banks will have less money to lend out to business and consumers and also the value of money multiplier will decrease. Thus the money supply will decrease.

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