Federal Reserve System
Federal Reserve System
. Explain two ways by which the Federal Reserve System can increase the monetary base.
Why is the effect of Federal Reserve actions on bank reserves less exact than the effect on the monetary base?
The monetary base refers to the total money in circulation plus deposits held in commercial banks and reserves held by the central bank (Lunsford, 2018). The Fed can increase its monetary base by purchasing open market operations and extending discount loans (Judd & Rudebusch, 2020). Under the open market operations, the Fed can buy government bonds. The Fed will have to print more money to purchase government bonds. As a result, the monetary base will increase since the money in circulation will be more. Furthermore, the acquisition of bonds by the Fed is an expansionary monetary policy that would increase the money supply (Lunsford, 2018).
The other way of increasing the monetary base is through reserve requirements. The Fed can increase the reserve-deposit ratio of commercial banks. Simply put, commercial banks can keep more reserves than deposits. By retaining few deposits, the commercial banks can issue more loans, thus increasing the money supply (Judd & Rudebusch, 2020). Similarly, an increase in reserve ratio will increase the monetary base. However, the effect of Federal Reserve actions on bank reserves has less impact on the monetary base because the Fed has limited control over the level of bank deposits.
- Explain two reasons why the Fed does not have complete control over the level of bank
deposits and loans. Explain how a change in either factor affects the deposit expansion process.
The Fed does not have control over the level of bank deposits and loans because their central bank reserve requirements only apply to the percentage of deposits of a commercial bank. Although the central bank can control lending through reserve requirements, it is ineffective since it does not apply to all bank deposits. The role of the Fed is to offer a regulatory framework and guide the actions of commercial banks, but it does not fully determine the activities of the financial institutions. For instance, the base capital control is a regulatory tool used by the Fed to control bank profits, but this have impact only in the short term (Judd & Rudebusch, 2020).
Secondly, the banking system consist of mostly privately owned banks free to operate within their rules (Judd & Rudebusch, 2020). There is no statutory organization that totally guides the operations of commercial banks. Since the banks operate freely, the will then decide on the level of reserves to keep and the amount of loans to give. Therefore, the central bank does not have control over the banks’ deposits and loans but only guide their operations to some extent. Changes in factors such as bank reserves and lending rates affect the deposit expansion process. For example, and increase in lending rate will reduce the amount of loans but increase deposits (Lunsford, 2018).
- Suppose the economy is currently in an inflationary gap. Describe the three tools in detail the Fed has to stabilize an economy growing too fast.
When the economy is in an inflationary gap, the real GDP must be higher than the potential GDP meaning the economy is growing too fast (Svensson, 2020). The economy cannot produce enough to satisfy the growing demand, thus the prices of goods and services are high. It results in disequilibrium, and the Fed can restore the economy through various tools. First, the Fed can increase bank reserve ratio. This will reduce money supply by limiting the amount of loans that commercial banks can offer. A decrease in money supply will reduce inflation rates and a result reducing inflation rate to stabilize the economy (Svensson, 2020).
Secondly, the Fed can reduce money supply through open market operations by selling government bonds. This will enable the Fed to reduce the circulation of money and thus reduce inflation. A reduction in money supply will reduce aggregate demand hence stabilizing the economy. Lastly, the Fed can use the discount rate to control the economy. Discount rate is the rate of interest the Fed charges potential financial institutions for short-term borrowing (Svensson, 2020). The Fed can increase the discount rate to limit borrowing and lending of commercial banks to reduce inflation and aggregate demand in the economy
Lunsford, K. G. (2018). Understanding the aspects of federal reserve forward guidance. Available at SSRN 3280584.
Judd, J. P., & Rudebusch, G. D. (2020). Describing Fed Behavior. In Handbook of Monetary Policy (pp. 281-284). Routledge.
Svensson, L. E. (2020). Monetary policy strategies for the Federal Reserve (No. w26657). National Bureau of Economic Research.