1. List three main tools available to the Fed to change the money supply in the
ID: 1248975 • Letter: 1
Question
1. List three main tools available to the Fed to change the money supply in the economy.Which tool do you think is most commonly used?
If the Fed wanted to decrease the supply of money in the economy, would the Fed buy or sell securities in the open market and what would be the first effect of this policy.
2.. Assume GDP is currently $5,600 billion per year and the quantity of money is $800 billion. What is the velocity of money? The nation collectively holds enough money to finance how many days worth of GDP expenditures?
Explanation / Answer
1. List three main tools available to the Fed to change the money supply in the economy.Which tool do you think is most commonly used?
The three main tools are that a Fed bank uses to control the money supply are:
1) Open market operation: through buying and selling of government bonds and securities.
If Fed buys bonds or securities from general public or commercial banks it is creating excess money or reserves , increasing the money supply. This increased excess reserves is used for lending by commercial banks.
If Fed sells securities, it drains out money from the market. So money supply will decrease in the economy.
2) Reserve ratio: federal reserve ratio, it is the amount (in the from of a deposit), a commercial bank need to maintain with the central bank (federal bank). By increasing the Fed R ratio, the commercial banks need to deposit more money in the central bank (federal bank), and hence money supply can be reduced.
By decreasing the reserve ratio, there will be excess money available to the commercial banks increasing the money supply.
3) Discount rate: The rate at which the Fed bank lends money to the commercail banks is called the discount rate. When the discount rate is low, the commercial banks will borrwo moeny from fed, this is an excess reserve and is readily availble foir lending. Thus increasing the money supply. If the Fed wants to decrease the money supply, it will raise the interest rate, discouraging borrowing, which restricts the money supply in the market.
If the Fed wanted to decrease the supply of money in the economy, would the Fed buy or sell securities in the open market and what would be the first effect of this policy.
For decreasing money supply Fed has to sell securties in the market, this makes the money to flow from the market to Fed reserve decreasing the money supply in the market. This decreased money supply increases the demand for money incrreasing interest rates.
2.. Assume GDP is currently $5,600 billion per year and the quantity of money is $800 billion. What is the velocity of money? The nation collectively holds enough money to finance how many days worth of GDP expenditures? Velocity of money is used to decsribe the rate at which money is exchanged in an economy at a given period. For example: If there are only two persons in an economy, a farmer and a doctor. And the economy has $50. Than if the Farmer visits the doctor ipon Jan and pays $50 And Doctor buys some food from farmer and pays him $50 Farmer visits for the scond time and pays him $50 than the toatl economic transations are $150 But the available money is only $50, but it is cycled thrice, Simply veocity is 3/year Velcoity can also be calcuted from GDP Velocity= GDP/ quantity money supply = 5600/ 800 = 7 times/year. Velocity is the avergae frequency with which a unit of money is spent in a specfic time period. The nation collectively holds enough money to finance how many days worth of GDP expenditures? Velocity= 7per year Per day expenditure of the economy= 5600 billions/365 =15.34 billions. Available money supply= 800 billins. cleective holding of money enoungh to pay for= 800/15.34 = 52 days. Alternatively we can caliculte it from velocity of money. Money avialable for one cycle= 365/7 = 52 days.
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