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Describe how the Federal Reserve can affect the money supply and interest rates.Identify and describe the effects of a change in money supply on the interest rate.Describe the money multiplier and the money creation process.Describe the likely change in equilibrium output and…
1. The Fed uses the following tools to affect the money supply/interest rates: – The Required Reserve Ratio – requires banks to retain a certain percent of the money they loan out (so they can’t loan all of it out). If the ratio is increased, the MS decreases and vice verse. – Buying/selling of Bonds (aka Open Market Operations) – if the Fed buys bonds, they increase the money supply, if the sell them, the MS decreases. – Discount Rate – This is the interest rate that bank must charge other banks. If a small bank issues to many loans and all of its customers want their money now, the little bank must go to a different bank to borrow some money however they will have to pay interest on this borrowed money. If the Discount Rate is too high, the little bank will keep more money on reserve so they will not have to pay a high interest rate. If less money is on reserve, more money is in the public, thereby increasing the money supply (if the Discount Rate is low, the opposite happens). 2. A change in the money supply will have vast effects on the interest rate. If the money supply is low, the interest rate will increase. With a low money supply, banks will need to pay people more to save their money at their bank because money is hard to come across. If the money supply is high, the interest rate will be low because money will be plentiful (i.e. if you won’t do business with the banks, someone else will). 3. In the money creation process, the money multiplier refers to a…

r” or number that you can multiply by the amount of money given. Example, lets say we’re talking about $1000 in demand deposits. Well the multiplier will tell us how much this money actually worth to the GDP (I’m going to use a multiplier of 3). 1000 x 3 is 3000. How does $1000 become $3000 you ask? Well, if I have $1000 and I spend it on a guitar, the person who sold me that guitar will then take a portion of the 1000 and then spend it on something else like a PS3 and he will save some of it. Then the man who sold him the PS3 will take his money and buy steak dinners for him and his friends and so on and so forth until that $1000 that you spent, contributed $3000 to the GDP. 4. If there is a change in interest rates outputs and price levels will likely do the opposite of whatever the interest rate does. If a flashlight business has $1000, they can either save that money in the bank or they can buy new materials to make more flashlights. Well lets say they make a total profit of $20 by purchasing $1000 worth of flashlight material and then converting them into flashlights and then selling them. If the interest rate is 5% then they can get $50 by just saving their money in a bank. Obviously, that is what they’re going to do. This means that there are less flashlights on the market. Output goes down, prices go up.



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