(Monetary Control) Suppose the money supply is currently $500 billion and the Fed wishes to increase it by $100 billion.
a. Given a required reserve ration of 0.25, what should it do?
b. If it decided to change the money supply by changing the required reserve ratio, what change should it make? Why may the Fed be reluctant to change the reserve requirement?
The Feds will have to purchase twenty five billion dollars in government securities in order for interest to be applied increasing the funds to $100 billion.
a. To increase the money supply by $100 billion, the Federal Reserve can use open market operations. Open market operations involve the buying and selling of government securities, such as Treasury bills and bonds, in the open market. By buying these securities from banks or other financial institutions, the Fed injects additional money into the economy, increasing the money supply.
In this case, the Fed wants to increase the money supply by $100 billion. To do so, it can purchase $100 billion worth of government securities from banks. Since the required reserve ratio is 0.25, banks are required to hold 25% of their deposits as reserves. Therefore, a $100 billion injection into the system would result in a multiplier effect, where the initial injection is multiplied by the inverse of the reserve ratio. Let's calculate it:
Initial injection = $100 billion
Reserve ratio = 0.25
Multiplier = 1 / (reserve ratio) = 1 / 0.25 = 4
Therefore, the total change in the money supply will be the initial injection multiplied by the multiplier:
Change in money supply = Initial injection * Multiplier = $100 billion * 4 = $400 billion
So, the Fed needs to buy $100 billion worth of government securities to increase the money supply by $400 billion.
b. If the Fed decided to change the money supply by changing the required reserve ratio, it would need to adjust the ratio to achieve the desired change in the money supply. The required reserve ratio determines the proportion of deposits that banks must hold as reserves and can lend out the rest. By increasing or decreasing the required reserve ratio, the Fed can influence the lending capacity of banks and, consequently, the money supply.
However, the Fed may be reluctant to change the reserve requirement for a couple of reasons. First, changing the reserve requirement can have a significant impact on the banking system and potentially disrupt the stability of the financial sector. Second, it may not be the most effective tool for controlling the money supply, as it directly affects the lending capacity of banks and can have unintended consequences. Therefore, the Fed tends to rely more on other tools, such as open market operations and adjusting interest rates, to manage the money supply.