Question

The Fed wants to increase the money supply (which is currently $6,000) by $300. The money multiplier is 4, and people hold no cash. For each 1 percentage point the discount rate falls, banks borrow an additional $30. Explain how the Fed can achieve its goals using the following tools:

a. Change the reserve requirement.
The Fed should lower/raise the reserve requirement to ____ percent.

b. Change the discount rate.
   The Fed should raise/lower the rate by _____ percentage points.

c. Use open market operations.
    The Fed should sell/buy $_____ worth of bonds.

Answer 1

A.

At multiplier of 4, reserve requirement = 1/4 = 25%

Money initially issued = 6000/4 = $1500

Now, to make the total money supply of 6300, the multiplier required = 6300/1500 = 4.2

So, new reserve requirement = 1/4.2 = 23.8% or 24%

So, Fed should lower the reserve requirement to 24%.

B.

Money required to be borrowed = 300/4 = $75

Hence, discount rate to be lowered = 75/30 = 2.5%

So,

Fed should lower the rate by 2.5 percentage points.

C.

Fed should buy = 300/4

Fed should buy = $75 worth of bonds