Federal Reserve system - Essay Example

Changing the reserve requirements. The banking system is required to keep a certain amount of the deposits in reserve, while the rest is given out in terms of loans. This amount which is defined in terms of reserve ratio determines the amount of money the financial institutions can create out of the deposits reserved. The FED can either increase or decrease the money supply by altering the reserve ration required from the banking system. When the reserve ratio is lowered the banking system will be required to decrease the deposits in reserve, thus increasing the lending capacity.

This in turn will increase the money supply. Alternatively, if FED raises the reserve ratio the banks will be forced to increase their reserve deposits and thus lower the lending capacity. This will eventually decrease the money supply. Changing the reserve requirements is potentially the most powerful tool because a small change in the reserve can causes big changes in the money supply within a very short time. Open market operations. This is the most commonly used tool in the daily operations, and is concerned with the purchases and sales of the government in the open market.

FED controls the money supply by either buying or selling the government bonds. . Banks create money by borrowing from the FED reserves or taking account receivables to FED. FED in turn imposes a discount on the loans made. Money supply can be increased by decreasing the discount rates which encourage banks to borrow more from the Federal reserves. Conversely, a lower discount rate will discourage banks from borrowing and thus lower money supply. Question two Easy money policy A 10 Real rate of Interest (%) 8 6 125 150 175 Amount of money demanded and supplied ($ billions) B Real rate of 10 Interest and Expected 8 Of profit (%) 6 investment demand 15 20 25 Amount of investment ($ billion) C P 3 Price level AD3 P 2 AD2 P 1 AD1 0 Q1 Q2 Q3 Real GDP ($ billion) Tight money policy A 10 Real rate of Interest (%) 8 6 125 150 175 Amount of money demanded and supplied ($ billions) B Real rate of 10 Interest and Expected 8 Of profit (%) 6 investment demand 15 20 25 Amount of investment ($ billion) C P 1 Price level AD1 P 2 AD2 P 3 AD3 0 Q3 Q2 Q1 Real GDP ($ billion) A = the money market B = Investment demand C= Equilibrium real GDP and the price level Easy money policy can be achieved by making money less expensive to borrow.

This means that FED can buy government bonds, decrease the federal funds rate, or decrease the reserve requirements. On the other hand, tight money policy is achieved by making money more expensive to borrow. FED can sell government bonds, increase the federal funds rate, or increase the reserve requirements. Question three The use of monetary rule by FED is based on Taylor’s assumptions of macroeconomics. In this model, price and inflation are steered by three factors; Employment Index, Consumer Price Index, and producer prices (Twomey,