Question

a) How does the open market operations increase the number of dollars in circulation?

b) How does the reserve ratio influence the money supply?

c) What do you think happens to the money multiplier (M) in a financial crisis and what is the likely impact of change in M to the economy?

Answer 1

a) Open Market purchases increases the number of dollars in the circulations. In open market purchases, the Fed purchases government securities in the open market from the public as well as the government. When the Fed purchases , it has to pay the amount equivalent to the bond price to the public or the government. As the Fed is paying out money, there is an increase in the number of dollars in the circulation.

b) The reserve ratio is the proportion of deposits that any bank has to keep as reserves. For example, a bank has deposits of $100. If the reserve ratio is 10%, it would mean that out of the deposits of $100, the bank has to keep $10 as reserves. If the reserve ratio is higher, then the bank can use lesser deposits as lendings and thus this would lead to a fall in the money supply. On the other hand, if the reserve ratio is low, the bank can lend out more money which would lead to an increase in the money supply.

c) When there is a financial crisis, the money multiplier falls as can be seen is the case during 2008 crisis. The money multiplier then fell from 9 to 4.5 before going down to 3. As the money multiplier falls, the money supply in the country falls leading to an aggravation of the crisis andd thus becomes difficult to revive the economy.