The Power of Monetary Policy: Increasing the Money Supply

How does the Federal Reserve impact the money supply?

What factors determine the total increase in monetary base and money supply when the Fed purchases government securities from banks?

Answer:

The total increase in the monetary base can be calculated by multiplying the amount of government securities purchased by the Fed by the required reserve ratio. In this case, the Fed purchases $1 million of government securities, and the required reserve ratio is 10 percent. So, the correct answer is $100,000 for the total increase in the monetary base and $2 million for the total increase in the money supply (M1).

Therefore, the total increase in the monetary base is $1 million x 10% = $100,000. To calculate the total increase in the money supply (M1), we need to consider the currency-deposit ratio and the fact that banks loan all excess reserves. The currency-deposit ratio is 5 percent, which means that 5 percent of deposits are held as currency. Since banks loan all excess reserves, we can assume that none of the $100,000 increase in the monetary base is held as excess reserves. Therefore, the total increase in the money supply is $100,000 x (1/0.05) = $2 million.

Monetary policy plays a crucial role in managing the money supply in an economy. By purchasing government securities, the Federal Reserve can inject funds into the banking system, which leads to an increase in the money supply. This, in turn, can stimulate economic activity and promote growth.

Understanding how the Fed's actions impact the monetary base and money supply is essential for policymakers, economists, and investors alike. By grasping these concepts, individuals can make informed decisions and adapt to changes in the financial landscape.