Open Market Activity & The Money Supply
Post your responses here by due date. Answer any 5 of the following 7 questions:
1) “The Federal Reserve System is structured in such a way as to insulate monetary policy from the political pressures characteristic of the rest of our political system of representative democracy.” Do you agree or disagree with this quote? Explain your answer.
2) a) In what sense does the Fed “create money”?
b) Suppose that the minimum required reserve ratio for banks was 1/11. Also suppose that banks held no excess reserves and that currency in circulation was unchanged. What action in the Treasury bill market would the Fed have to take to increase bank checking account deposits by $990 million?
3) Assuming that banks used all their excess reserves to support an increase in the volume of bank lending, by how much would bank lending expand if the Fed undertook the policy action that was your answer to question (2)?
4) Suppose that households in the U.S. increased their desired holdings of currency by $55 million as the Fed was adding reserves to the banking system. How would your answer to question (2) be affected, assuming that the Fed still wished to generate an increase of $990 million in checking account deposits?
5) Suppose that households in the US switched some of their wealth out of their checking accounts and into short term bank CD’s. If banks use all excess reserves to support increased lending, what is the effect on this household behavior on the overall volume of bank lending? What is its effect on the level of M1?
6) What is the difference between the Federal Reserve’s “discount rate” and the “federal funds” rate? Why is the discount rate in the US not as important in financial markets as the federal funds rate?
7) Why is it not possible for the Fed to predict exactly how large an increase in the money supply (M1) will result from a given open market purchase.
2) Draw a supply-demand diagram of the Federal funds market which illustrates the effects of a massive treasury bill sale by the Fed in the open market.
3) If banks desire to increase their lending, but the Federal Reserve is not adding reserves to the banking system, what will happen to the level of short term interest rates? Explain your answer carefully.
4) “Sweep” accounts are combination checking/money market accounts which large banks currently offer to their corporate customers. These accounts sweep just enough funds out of the money market portion of the account to prevent checks written on the checking part of the account from bouncing. Suppose that banks suddenly made these accounts available to households. Draw a supply/demand diagram of the federal funds market to show the effect on the federal funds rate if the Fed did nothing. What action in the open market would the Fed have to take to maintain its existing interest rate target under these circumstances?
5a) Explain carefully why interest rates on each of the following short-term financial instruments will be closely tied to the level federal funds rate: short-term bank CDs, short-term Treasury bills, short-term commercial paper.
5b) Why is the yield on short-term Treasury bills usually less than the federal funds rate?
6) Suppose households and small firms withdrew funds from banks in response to rumors circulating that a computer virus would destroy banks customer account databases. What action would the Fed have to take in the open-market to maintain its existing fed funds target rate?
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