Question

What is the potential impact on the money supply of an open market sale by the FED of \(\$ 3,000,000\) in government bonds, assuming all commercial banks are fully "loaned up" (i.e., their excess reserves are zero), and the required reserve ratio is \(25 \%\) ?

Short answer

The potential impact on the money supply of an open market sale by the Federal Reserve (FED) of $3,000,000 in government bonds can be calculated using the money multiplier concept. Given that the required reserve ratio is 25%, the money multiplier is \( \frac{1}{0.25} = 4 \). Therefore, the potential decrease in money supply, which is the decrease in reserves multiplied by the money multiplier, equals \( \$3,000,000 \times 4 = \$12,000,000 \). Thus, the money supply could potentially decrease by \$12,000,000.

Step-by-step solution

Understand the context of the exercise

The FED sells government bonds of \$3,000,000 to the commercial banks through an open market operation. This transaction will decrease the banks' reserves by \$3,000,000, affecting the money supply in the economy.

Calculate the Money Multiplier

The money multiplier (MM) is the amount of money that banks generate with each dollar of reserves. It can be calculated as reciprocal of the required reserve ratio. Here, the required reserve ratio is 25%, or 0.25. So, the money multiplier (MM) is \( \frac{1}{0.25} = 4 \).

Determine the potential impact on the money supply

The Money Supply (MS) is the total amount of money available in an economy at a specific time, and it decreases due to the decrease in reserves. The decrease in money supply (ΔMS) is equal to the decrease in reserves multiplied by the money multiplier. Given that the decrease in reserves (ΔR) due to the open market sale is \$3,000,000 and the money multiplier (MM) is 4, the potential decrease in money supply (ΔMS) caused by the FED's open market sale will be \( ΔMS = ΔR \times MM = \$3,000,000 \times 4 = \$12,000,000 \). So, the potential impact on the money supply of an open market sale by the FED of \$3,000,000 in government bonds is a decrease of \$12,000,000.

Key concepts

Money Multiplier

Understanding the money multiplier is pivotal when examining the effects of central bank policies on the money supply. The money multiplier refers to the ratio of the amount of money that a banking system can generate for every unit of reserves. To clarify, reserve here signifies the portion of depositors' balances that banks have retained in their vaults or deposited at the central bank and thus is not loaned out.

The formula for the money multiplier is: \[ MM = \frac{1}{RRR} \] where \( MM \) denotes the money multiplier and \( RRR \) represents the required reserve ratio. If the required reserve ratio is 25% or 0.25, the multiplier is 4. This means that every dollar of reserves can theoretically turn into four dollars in the banking system through lending and deposit cycles.

This concept is significant because it shows how a single financial action by the central bank can amplify to affect the broader economy. However, it is important to note that real-world constraints, such as banks holding excess reserves or borrowers repaying loans faster, can cause the actual multiplier effect to deviate from the theoretical maximum.

Required Reserve Ratio

The required reserve ratio (RRR) is the fraction of customer deposits that banks must hold as reserves, either in their own vaults or at the central bank. This ratio is set by the central bank as part of its monetary policy to ensure that the banks have enough funds on hand to meet the demands for withdrawals by customers.

When the central bank adjusts the RRR, it directly impacts the amount of money that banks can lend. A lower RRR means banks have more funds available to loan out, potentially increasing the money supply, while a higher RRR does the opposite, reducing the money available for lending, and thereby potentially decreasing the money supply.

In our example, with a RRR of 25%, banks are required to keep a quarter of all deposits as reserves. This high required reserve ratio implies a lower capacity for banks to create new money because a significant portion of deposits is locked away and cannot be used for lending purposes. Adjusting the RRR is a powerful tool within the central bank's arsenal to control the money supply, influence economic activity, and maintain financial stability.

Central Bank Monetary Policy

Central banks, such as the Federal Reserve (FED) in the United States, are tasked with managing the country's monetary policy. Their primary goal is to maintain price stability and foster economic conditions that lead to low unemployment and stable economic growth. One of the key instruments they use to accomplish this is open market operations (OMOs).

OMOs involve the buying and selling of government securities in the open market. When the central bank sells government bonds, as in our textbook example, it effectively reduces the reserve balances of commercial banks, limiting their ability to create new money. Conversely, purchasing securities adds to banks' reserves, providing more potential for lending and expanding the money supply.

• If the FED believes the economy is running too hot and inflation is a concern, it can sell securities to reduce the money supply (contractionary policy).
• On the other hand, if the economy needs a boost, the FED can purchase securities to increase the money supply (expansionary policy).

The impact of such policies on the money supply is crucial because it influences interest rates, inflation, consumer spending, and overall economic activity. The FED's open market operations, alongside adjustments to reserve requirements and discount rates, represent the triad of tools used to conduct monetary policy effectively.