- December 4, 2020
The major tools that the Fed may adopt to control the country’s money supply are :
- The Required Reserve ratio (RRR) is the percentage of its total deposits that a bank must keep as reserves at the Fed. The Decreases in the RRR allows banks to have more deposits with the existing volume of reserves. Banks create money by making loans. When a bank makes a loan to a customer, it creates a deposit in that customer’s account. This deposit becomes part of the money supply. As banks create more deposits by making loans, the money supply increases. Banks can create money only when they have excess reserves.
- The Discount Rate (DR): The Interest Rate that banks pay to the Fed to borrow from it. Bank borrowing from the Fed leads to an increase in the money supply. The higher the discount rate is, the less borrowing, banks will want to do.
- Open Market Operations (OMO): The purchase and sale of government securities in the open market by the Fed. An open market purchase of securities by the Fed results in an increase in reserves and an increase in reserves and an increase in the money supply. An open market sale of securities by the Fed results in the decrease in reserves and a decrease in the money supply.
These tools are thus being used to increase and decrease the money supply in the U.S. economy
The economic variables that are determining the demand for money are :
The demand for money depends negatively on the interest rate. The Interest Rate is the annual interest payment on a loan expressed as a percentage of the loan. It is equal to the amount of interest received per year divided by the amount of the loan. The higher the interest rate, the higher the opportunity cost ( more interest forgone) from holding money and the less money people will want to hold. An increase in the interest rate reduces the quantity demanded for money, and the money demand curve slopes downward.
The volume of transactions in the economy affects money demand. The total dollar volume of transactions depends on the total number of transactions and the average transaction amount. It is positively related for Aggregate Output (Y) and Price Level (P). The quantity demanded for money is a stock variable, not a flow variable, and is measured in a given point of time. Increases in the price level increase the demand of money because households and firms need more money for their expenditures. Decreases in the price level decrease the demand for money.
The Economic Analysis of Demand for Money based on the following assumptions:
- Only two types of assets are available, i.e. money and bonds. Bonds represent all kinds of interest bearing securities; money represents currency in circulation and in deposits, neither is interest bearing.
- Household income comes in once a month and at the beginning of the month. Household spending spread out over time in a uniform rate throughout the month ( the same amount each day).
- Spending for the month is exactly equal to income for the month.