The Federal Reserve and Monetary Policy


This report covers the impact that changes in the financial environment have on the economic variables of money demand and supply and interest rates.

The Fed buys securities in the open market

Open market operations are one of the most powerful tools that the Fed possesses to control money supply in the main Markey. The Fed buys government securities in the open market when it wants to add to the reserves of the banks. The buying of securities results in an increase of money supply in the market. The process works something like this, the Fed buys up the securities from the reserve bank, after this the bank has basically more funds which to lend to the market basically an increase in money supply. The interest rate is derived from the interactions in the money market which includes demand and supply of money. An increase in money supply is likely to put a downward pressure on the interest rates. The demand for money is dependent on many factors including inflation, real GDP growth and interest rates. However it can be assumed that a decrease in interest rates will result in an increase in demand for money (MI and M2). Generally the Fed engages in buying of securities when it fears an economic slowdown. For example in recent economic history of recession the Fed has been engaged in buying of securities (eg promise to buy one trillion worth of securities on March 18 2009) in order to spur economic growth. Economic growth is spurred due to the downward pressure on interest rates which means it becomes cheaper to do business.

Money Supply  ↑

Interest Rates  ↓

Demand for Money (dependent on many factors) however ↑

The reserve requirement is increased

The reserve requirement is one of the least used tools by the Fed to control money supply. This is mostly because changing reserve requirements is less accurate(in the sense that it is harder to measure the exact impact on money supply) then conducting open market operations. This is because it would affect each depository institution differently, depending on what their deposit base is. The reserve requirement is set by a reserve ratio which the Fed sets. The reserve requirement tool works this way; if the Fed increases the reserve requirement that would mean that more of the money will go to the Fed rather then into the market. That means that an increase in the reserve requirement would result in a decrease in the money supply.

Money Supply ↓

Interest Rates ↑

Consumers decide to save and reduce their spending on consumer goods

Consumer spending accounts for a significant part of the economic activity in America and constitutes a huge chunk of total aggregate demand. In recent recessionary times the tough job market has significantly brought down consumer spending. One significant impact that reduced consumer spending will have is reduction in the demand for money. Generally one of the things that result in reduced consumer spending and increased saving is an increase in interest rates which attracts individuals to save rather to spend.

Money Demand ↓


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The American Consumer – Consumer Spending, Job Creation, And Interest Rates.

What effect does a change in the reserve requirement ratio have on the money supply?

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