A. Describe three tools the Fed can use to raise interest rates. For each tool,

Question

A. Describe three tools the Fed can use to raise interest rates. For each tool, clearly state how it is used for this objective. 3-7 sentences.

B.Suppose that the reserve requirement ratio is 5% and that the Fed uses open market operations (OMO) by SELLING $60 million worth of Treasury securities. Assume that banks use all funds except required reserves to make loans and that the public does not store any cash. Given the information above, what is the best estimate of how much the money supply changes as a result of the Fed’s action? Be sure to state the direction (increase or decrease) as well as the amount. Show your work

Explanation / Answer

A. The three tools that the Fed can use to raise interest rates are:

1) Open Market Operations: In this tool, the Fed uses purchasing and selling of bonds to change interest rates. The bonds are bought from or sold to the private banks in order to change interest rates. If the Fed wants to reduce interest rates, it purchases bonds from the banks and it adds cash to the banks' reserves. This leads to the banks having excess reserves. Thus, the bank then reduces interest rates so as to lend out the excess reserves. The opposite happens in the case of an interest rate hike.

2) Reserve requirement: This is the money that banks must keep with them overnight. This is kept as a percent of the demand deposits that a bank receives. If the reserve requirement is high, banks can lend out less as loans and money supply is low. Similarly, if the reserve requirement is low, banks can lend out more loans and money supply is high.

3) Discount rate: This is the rate at which banks borrow from Fed. If this is high, cost of borrowing for Fed is high and thus interest rates rise. If this is low, cost of borrowing is low, and interest rates fall.

B. The change in money supply is equal to:

m x Open Market sale, where m is the multiplier.

m = 1/ Reserve ratio => m = 1/0.05 = 20

Change in money supply = 20 x $60 million = $1.2 billion

Since, there is OMO sale, money supply decreases. Hence the best estimate of the change un money supply is a decrease in money supply by $1.2 billion.

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