Question

As the U.S. economy approached the millennium, January 1, 2000, many people cautiously began to hold larger than normal quantities of currency as protection against a possible disruption of banking services that could result from computer glitches.

a.	How did this greater preference for currency affect the money supply?
b.	How could the Federal Reserve offset such an increase in currency preferences?

Answer 1

(a) Higher preference for currency will increase the currency drainage ratio, which will decrease the money multiplier.** As money multiplier falls, money supply in the economy will increase.

(b) Fed can offset the decrease in money multiplier caused by higher preference for currency by decreasing the discount rate. Lower discount rate will increase the credit lending activity of commercial banks, which will increase overall money supply. The lower the discount rate, the more the Fed can offset the fall in money supply due to currency drainage by a rise in credit lending.