6. Suppose that current money supply is $8,000. The required reserve ratio is 0.

Question

6. Suppose that current money supply is $8,000. The required reserve ratio is 0.5 If the Fed wishes to decrease the money supply by $500. Determine the following:

All underlying work must be shown

a. What open market operation the Fed would have to take to achieve the stated desired change in the money supply.

b. Refer to the diagrams below, which one illustrates the open market operations the Fed would have to take to achieve the stated desired change in the money supply from your answer to part b?

c. Explain what will happen to these bonds prices and interest rates associated with these bonds

d. How much should the Fed buy or sell in the government bonds to achieve the stated desired change in the money supply.

e. What would the money supply in the economy be as the result of the Fed action?

f. What would happen to the short-term nominal interest rates?

g. Is the Fed making the monetary policy more expansionary or contractionary? Explain

Explanation / Answer

The Fed open market committee will sell securities to achieve the desired result. The FOMC will sell securities in the form of bonds and notes which will lead to money to be withdrawn from the bank and kept in the FOMC reserves. Under contractionary money policy the central bank sells the securities which reduces the amount of money in circulation. This in return affects the rates at which the banks borrow the reserves from one another to meet their requirements, this is called as the federal fund rate, further the short term interest rates offered by the banks are based on these federal fund rate which in return directly or indirectly influence the interest rates faced by the consumers and the businesses. Money multiplier = 1/ reserve ratio = 1/0.5 = 2. Thus to decrease supply by $500 the FOMC will sell securities worth $500*2=$1000 The new money supply will be $7500. The short term nominal interest rate will increase due to the law of demand and supply. It’s a contractionery policy since this action will reduce the money supply in the market.

Related Questions

Navigate

• Browse (All)
• Browse 6
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.