Question

Suppose that the Federal Reserve wants to reduce the money supply.

a.         Explain the three main policy instruments the Fed could use to reduce the money supply. In each case, detail how these policy actions are supposed to work, including the role of the private banks.

b.         Using our model of the money market, investment, and aggregate demand and aggregate supply, explain the how a reduction of the money supply will influence the price level and real GDP, assuming that the economy is operating in the moderate unemployment range of aggregate supply.

Answer 1

a) Instruments that Fed can use to reduce money supply:

• Reserve Ratio requirements: It is the ration of money which Fed keep it with themselves for unexpted reasons and lend the rest of it. It they wants to reduce the money supply, they can raise this ratio such that less money is injected in the economy.
• Margin Requirements: Fed can raise margin Requirements such that they keep a large portion of the money they loan out.
• Discount Rate: Fed raises the discount rate which reduces excess reserves in commercial banks and reduce money supply in the economy.

b) When Fed reduces money supply in the economy, there is less money in tha hands of public which reduce their willingness to pay for goods and reduce aggregate demand in the economy. It shifts aggregate demand curve to its elft reducing price level from P to P1 and output falling from Y to Y1.