The monetary system in any economy facilitates trade and allows people to trade

Question

The monetary system in any economy facilitates trade and allows people to trade more efficiently, as compared to a barter economy. In the United States, the monetary authority is the Federal Reserve System (also referred to as the Federal Reserve, or informally, as the Fed.)

For this assignment, use the information presented in the textbook and the Feds website (http://www.federalreserve.gov/) when addressing the questions below.

6- What are the tools available to the FED for controlling the money supply? Which are used most often? Which are most effective?

7- How does the money multiplier help to determine the effects of monetary policy?

8- What are the pros and cons of using monetary policy, as opposed to the use of fiscal policy, for implementing economic policies and practices?

Explanation / Answer

(6)

Fed has the following tools for controlling money supply.

(a) Open Market Operations (OMO)

To control inflation caused by excess money supply, Fed sells bonds in open market to mop up excess money supply, thus taming inflation.

To combat deflation, Fed buys bonds in open market, enhancing money supply.

(b) Reserve ratio requirement

Reserve ratio specifies the percentage of deposits that banks must set aside as reserves not available for lending purposes. To increase (decrease) money supply, Fed decreases (increases) required reserve ratio, making more (less) money available for credit lending purposes.

(c) Bank rate

This is the rate charged by Fed to commercial banks to which Fed lends money. To increase (decrease) money supply, Fed decreases (increases) bank rate, making more (less) money available for credit lending purposes.

The OMO is used most often and most widely, since it makes the most immediate and direct impact on money supply.

(7)

Money multiplier is the inverse of reserve ratio, and it determines the total increase in money supply out of the amount of new deposits created.

For example, assume the reserve ratio as 10%, meaning banks must set aside $10 out of every $100 of new deposits, lending out $90 only. Here, the money multiplier will be (1 / 0.10) = 10, and total money supply increase out of $100 of new deposits will be $100 x 10 = $1,000.

Hence, an increase (decrease) in reserve ratio will decrease (increase) the money multiplier, which in turn will decrease (increase) total money supply.

(8)

Pros of monetary policy are:

- Easy and quick implementation by central bank, to correct the economy.

- Central banks act independently of the government, and can therefore take independent decisions to the best interests of economy by bypassing political agenda and bureaucracy.

- Interest rate as an instrument of money supply control directly affects the investment, therefore impacting the money supply.

- Increase or decrease in money supply and therefore inflation will depreciate or appreciate the domestic currency, therefore the exports can be increased or imports decreases using the monetary policy, thus affecting balance of payments.

Cons of monetary policy are:

- Time lags between an economic situation being recognized, the actions decided on and implemented, and the effects of the policy reaching the economy will delay the monetary policy impact.

- If interest rates are kept too low, there is risk of uncontrollable high inflation and a liquidity trap situation, when investment can no longer be stimulated by interest rate.

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