Question

Suppose the Federal Reserve wants to increase the money supply by increasing the lending potential of commercial banks. Assume the current reserve requirement for commercial banks is 20 percent. Now suppose the Fed wants the lending potential to increase by $180 billion, and it plans to use open-market operations to accomplish this goal.

Answer 1

(a) Required reserve ratio = 20%

Money multiplier = (1 / required reserve ratio) = (1 / 0.2) = 5

In order to increase the lending capacity Fed should buys the government securities in the open market.

Fed wants to increase the lending capacity increase by $180 billion.

Amount of government securities buys = (Increase in lending capaicty / money multiplier)

Amount of government securities buys = ($180 billion / 5)

Amount of government securities buys = $36 billion

The fed will need to buy government securities in the total amount of $36 billion.

(b) The Fed may also opt to use some amount of reserve repos to effectively lend money to commercial banks rather than permanently transfer owernship of the securities in order to obtain its goals.