Question

Read pp. 757-760 of Chapter 25(Sexton, 2016). Explain how the government can reduce the money supply using (1) the reserve requirement and (2) open market operation. DO NOT discuss 'discount rate' please in your essay. You will be marked down substantially for including discussions on 'discount rate'.

(Due: Day 4 (Thursday) by 11:59pm; word count: minimum 300 words)

Answer 1

The government can reduce money supply by engaging in contractionary monetary policy.

This can be done by either increasing reserve ratio or engaging in open market sale of government securities.

1. When reserve requirement ratio is increased, it means banks will have to keep a larger portion of their deposits as reserves with Fed, which would reduce their lending capacity and thus reduce loans and money supply in the economy.

2. When open market sale of government securities is done, it means Fed is selling securities in exchange of money. This will reduce money in circulation and thereby reduce money supply.

Thus, these two actions will reduce money supply in the economy.