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Unformatted text preview: combination of tools they may use are as follows: 1. 2. 3. Open market operations (for minor adjustments in the money supply) Change in reserve requirements (for more radical adjustments) Change in discount rate (for more radical adjustments) Each member bank must set aside a certain percentage of its deposits in a reserve account. These reserves have a twofold purpose: (1) to have monies in reserve in case the bank finds itself short of funds to meet the demands of depositors, and (2) to control the amount of monies available to the bank for the purpose of making loans. For example, if the reserve requirement is 5% and the bank opens a new account in the amount of $1,000, it will have to put 5 percent, or $50, into the reserve account, thus leaving $950 to use for loans and the operation of the bank. How does the Fed use this tool? Let's assume the Fed feels that at the present time the economy is growing too fast and is feeding inflation and it wants to shrink the supply of money available to the banks. All it has to do is raise the reserve rate requirement, and the banks must then make deposits to their reserve accounts to meet the new requirement. For example, a small bank has deposits of $2 million and the reserve requirement is 5 percent. That means the bank has to have $100,000 on account with the Fed. Now the Fed feels that there is too much money to loan, so it doubles the reserve requirement to 10 percent. The bank must immediately double the amount of money on account at the Fed. This takes another $100,000 out of the hands of the bank and leaves it less money available to loan. This would not only be true for this small bank, but for all of the banks in the system, thus reducing the money available rapidly and in large amounts. We then go back to the law of supply and demand. With the supply reduced, the interest rate should increase and, it is hoped, the demand will slow. Another tool available to the Fed is to change the discount rate–the rate the Fed...
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This note was uploaded on 12/30/2010 for the course SOC 101 taught by Professor Zhung during the Spring '10 term at Punjab Engineering College.
- Spring '10