Money Creation and Open Market Operations. a. Briefly explain in words how the “

Question

Money Creation and Open Market Operations.

a. Briefly explain in words how the “money multiplier” is supposed to work (i.e., how, under the “textbook view” of banking operations, a Fed purchase of Treasury securities is said to result in a multiplied expansion of the quantity of money in circulation). What does Wright say are the limitations of this model of money creation? Also, discuss what options a bank would have if they had a lending opportunity, but didn’t have the reserves available for payment of the loan; what does this mean for the money multiplier story?

b. the Fed has not used money supply targets as a basis for open market operations since the early 1980s. What does the Fed use as a target instead? What actions does the Fed take to achieve this target?

imformation: the central bank pretty much controls the size of the monetary base. (The check clearing process and the government’s banking activities can cause some short-term flutter, but generally the central bank can anticipate such fluctuations and respond accordingly.) That does not mean, however, that the central bank controls the money supply, which, if you recall from Chapter 3 "Money", consists of more than just MB. (M1, for example, also includes checkable deposits.) The reason is that each $1 (or €1, etc.) of additional MB creates some multiple > 1 of new deposits in a process called multiple deposit creation.

Explanation / Answer

A. Money multiplier: Multiplier depeands on the reserve requirment on need to maintain. Example if a bank has a reserve requirment of 10%, then if bank receives 100USD he need to hold 10% of 100USD and lend the other 90USD to other bank customer. The customer who borrowed the cash from present bank deposits the amont in other bank directly or indirectly, hence from these 90USD bank recerves 10% i.e 9USD and lend 81USD to other customer, this process continues untill the intial 100usd is held as reserve with all the bank cumulated. In these process the 1000usd is lent to diffrent customers from the intial 100usd deposited.

Banks have mainly two ways of lending :

1. fund based lending; example: Home loan, personal loan, educational loan etc

2. Non fund basaed loan; example: Letter of credit, Bank guarantee etc.

As banks check there liquid positions and accept to lend the customer the situation of no funds rarley happens even such situation occur bank borrow money for short term in the market to manage there liquid positon for short term. Second option would be the bank can do non fundbased limits.

b. Open market operations are one of three basic tools used by the Federal Reserve to reach its monetary policy objectives. The other tools are changing the terms and conditions for borrowing at the discount window and adjusting reserve requirement ratios.

3. Money is manily classifed as M0, MB, M1, M2, M3 and MZM

M0 include bank reserves

MB is reffred to as monetary base or total currency

M1 dosen't include bank reserves

M2 includes M1 and close substitutes

M3 include M2 and large and long term deposits.

MZM are the money with zero maturity

As dicussed in part a of the answer the deposits produce multiple effect.

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