6. Understanding Fed policy tools Aa Aa B The Federal Reserve has several instru
ID: 1119807 • Letter: 6
Question
6. Understanding Fed policy tools Aa Aa B The Federal Reserve has several instruments of monetary control at its disposal. One such instrument is the reserve requirement. Which of the following statements about the reserve requirement are accurate? Check all that apply. O A decrease in the reserve requirement decreases the monetary multiplier. O Raising the reserve requirement would increase the money supply. O An increase in the reserve requirement decreases the quantity of excess reserves. O Reducing the reserve requirement would decrease the money supply. Another Fed instrument is the term auction facility (TAF). Which of the following statements about the term auction facility are accurate? Check all that apply. O It allows the Fed to make a specific change in bank reserves with certainty. O The mortgage debt crisis caused the Fed to introduce it in late 2007 It was introduced in response to the recession that began in 2001. O Bidders for funds under the term auction facility shout out their bids in an auction room at the New York Fed bank. Which one of the following Fed instruments of monetary control is typically the most important? O Open-market operations O Marginal tax rates O The discount rate O The required reserve ratioExplanation / Answer
(1) The reserve requirement ratio refers to the amount of high powered money the commercial banks would have to keep before giving loan to people. The high powered money is the amount of money given by the central bank (Fed) to the commercial bank, in terms of bond purchase. The thing is, the money multiplier, which is the final expansion of money by high powered money, is inversely proportional to the reserve ratio (RR).
Hence, an increase in the reserve requirements decrease the excess reserve. The excess reserve are amounts as deposits above the required reserves, and as the reserve increases, excess reserves decreases. Also, for other options, the fact is that decrease in RR increases the money multiplier and hence, increase in money supply, and vice versa.
(2) The TAF was introduced in late 2007, to help the economy to tackle mortgage debt crisis. Under this auction, banks found eligible by the Fed, bid for amounts as short term loans at a lower discount rate (set by the Fed), and it adds up to increase of loanable amount in the credit market. It is basically introduced to help in times of crisis, not as regular monetary policy.
(3) The most important instrument of any Fed, or any central bank's monetary control is open market operations, under which the Fed provides the high powered money to commercial banks in terms of purchasing their bonds.
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