Fed Tools for Changing the Money S upply

1. Fed Tools for Changing the Money Supply By Miles Overton and J-smash Hernandez Per: 1

2. Changing the Reserve Requirement • Think of the Fed as having three “buttons” to push • Every time a button is pushed either the money supply is raised or lowered • The first button is the reserve requirement • The equation to solve the money supply is : 1/Reserve requirement x Change in reserves of the bank Ex. (5% is the Reserve requirement) 1/.05 x $1,000 = $20,000 (10% is the Reserve requirement) 1/.10 x $1,000 = $10,000 (20% is the Reserve requirement) 1/.20 x $ 1,000 = $5,000

3. Continued… • Notice before when the supply was largest at $20,000 the reserve requirement was at 5% • & the supply is smallest at $5,000 when the requirement is at 20% • Thus the Fed can increase or decrease the money supply by changing the reserve requirement Lower reserve requirement  money supply rises Raise reserve requirement  money supply falls

4. Open Market Operations • The second button the Fed can “push” to change the money supply is the open market operations button • This 12 member committee ( FOMC) conducts Open market operations which buy and sell government securities by the Fed • Open market purchase  Money supply rises • Open market sale  Money supply falls

5. Changing the Discount Rate • The third button the Fed can push can change the money supply is the discount rate button • For example if bank M wanted to borrow $2 million dollars, it could borrow from bank J or the Fed • If they borrowed from bank J then the bank could charge an interest for the $2 million dollar loan, this is known as federal fund rate • If the money is borrowed from the Fed, they will charge an interest rate known as discount rate

6. Continued… • It does not matter which bank M chooses from pending the relationship between federal funds rate and discount rate • However, if the federal fund rate is lower than the discount rate then the choice would be bank J • But, if the discount rate is lower than the federal rate, the choice would be the Fed • The choice may be simple but could possibly have many ramification to it…

7. Continued… • If bank M were to borrow from bank J no new money would be entering the economy • However if bank M borrows from the Fed, the Fed then create new money in the process of granting loans • The Fed can grant by depositing the funds into a reserve account of the bank • The Fed lowers its discount rate to become lower than the federal rate & if the bank borrows money from the Fed supply increases

8. The Effects • If the Fed lowers the discount rate: • Lower the discount rate Money supply rises • Raise the discount Money supply falls

9. Fed Monetary Tools & Their Effects On the Money Supply Fed monetary tools Money supply • Open market operation Buys government securities Sells government securities • Reserve Requirement Raises reserve requirement Lowers reserve requirement • Discount rate Raises discount rate Lowers discount rate • Increase Decrease • Decrease Increase • Decrease Increase

10. The End

11. Citation • Arnold, Roger A.. Economics: new ways of thinking. St. Paul, Minn.: EMC Pub., 2007. Print.