1.) Explain what we would expect to happen to the money supply if the Federal Re

Question

1.) Explain what we would expect to happen to the money supply if the Federal Reserve sells $5.5 million worth of U. S. Government bonds while banks increase their discount loans by $3 million. Be as specific as possible in your answer given the information provided.

2.) Evaluate and Explain both of the following statements.

   a. "If banks increase their excess reserves, the monetary base will increase. If the monetary base increases, the

         money supply will increase. Therefore, an increase in excess reserves increases the money supply”.

    b. The most important factor accounting for changes in the money supply, in the long run, is changes in bank

        lending policies that affect the money multiplier.

Explanation / Answer

1) When Federal Reserve sells $5.5 million in bonds, the currency at hand, and the demand deposits value would fall because people buy the bonds. As a result the monetary base as well as M1 money supply would fall. The M2 supply would rise. When banks increase their discount loans by $3 million the currency in circulation as well as demand account would rise as people would take more loans. Consequently M1 falls but M2 rises by $2.5 million (= $5.5 million - $3 million)

2) a) If banks increase their excess reserves monetary base will increase because in the Federal Reserve the reserves of the banks will increase. Due to the rise in the monetary base there will be an increase in money supply due to the multiplier effect.

b) In the long run money supply changes are affected by the lending policies of bank’s. The lending policy refers to a set of guidelines and criteria developed by a bank and used by its employees to determine the grant or refusal of the loan. These are also important to people while determining where to invest in the money market- in certificates of deposits, in the mutual funds.

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