Question

The Fed wants to increase the money supply (which is currently $3,000) by $200. The money multiplier is 4, and people hold no cash. For each 1 percentage point the discount rate falls, banks borrow an additional $30. Explain how the Fed can achieve its goals using the following tools: a. Change the reserve requirement. Instructions: Enter your response rounded to the nearest whole number. The Fed should (Click to select) the reserve requirement to percent. b. Change the discount rate. Instructions: Enter your response rounded to two decimal places. The Fed should (Click to select) the rate by percentage points. c. Use open market operations. Instructions: Enter your response rounded to two decimal places. The Fed should (Click to select) $ D w orth of bonds.

Answer 1

a. The Fed should lower the reserve requirement to 23.44 percent.

Since money multiplier is 4, the current reserve reserve requirement is 1/4=25%. In order to increase the money supply by $200, Fed should lower the reserve requirement by 23.44%.

$Revised\: reserve\: requirement=\frac{3000}{3200}\times25=23.4375=23.44$

b. The Fed should lower the rate by 1.67 percentage points.

In order to increase money supply by $200, the discount rate should be lowered which will lead to increase in the amount of reserves, thereby increasing the money supply. As the money multilpier is 4 & Fed wants to increase money supply by $200, therefore, reserves should be increased by 200/4=50. As banks borrow an additional $30 for every point the discount rate is lowered, therefore, the Fed should lower the discount rate by 50/30=1.67 percentage points.

c. The Fed should buy $50 worth of bonds.

In order to increase money supply by using open market operations, Fed has to buy bonds which will lead to increase in reserves in the banking system. As the money multiplier is 4 & the money supply has to be increased by $200, the Fed should buy bonds equal to 200/4=$50.