FED In Action aThe most popular or frequently used tool of t

FED In Action: a)\"The most popular or frequently used tool of the FED is Open Market Operations [OMOs] and the most powerful is changing the reserve requirement for banks.\" Do you agree? Why or why not? Be specific and limit your response to one paragraph. b)For each of the listed independent scenarios specify the OMO action -- buy bonds or sell bonds -- would be appropriate and consistent with the FED\'s macroeconomic goals. Be sure to justify your specified action for each scenario: a) The unemployment rate is at an all-time high, and real GDP has fallen for two consecutive quarters; b) Real GDP is at a new peak and the unemployment rate is below the full employment rate, and the CPI has begun to increase above the maximum set by the FED.; c) The unemployment rate includes 4% of cyclical unemployment, the real GDP is growing at 2% per annum, and financial institutions are not lending money..

Solution

Even though the Constitution authorizes the government to \"coin money,\" it would be impractical to control its supply by speeding up or slowing down the printing presses. After all, if enough were printed it would soon be worthless. It is also impractical to tie the value of paper money to precious commodities such as gold or silver, since the supply of these commodities does not always keep pace with economic growth. Governments discovered that when these metals didn\'t keep pace with growth there was usually insufficient currency to finance investment and consumption. Therefore, the Fed relies on its legal authority to manipulate \"fiat money\": paper currency, coins, funds in checking and savings accounts, and other legally accepted forms of exchange.

Reserve ratios. Banks are required to maintain a certain proportion of their deposits as a \"reserve\" against potential withdrawals. By varying this amount, called thereserve ratio, the Fed controls the quantity of money in circulation. Suppose, for example, it orders banks to hang on to an extra 1 percent of their deposits. They would then have 1 percent less to lend. One percent may not sound like a lot, but it translates into billions of dollars that are siphoned out of the economy.

Open-market operations. By far the most important of the Fed\'s activities are open-market operations, the buying and selling of government securities. After Congress approves an increase in the national debt, the Treasury Department prepares a mix of bonds, bills, and notes that it auctions to private dealers who are authorized to trade government securities. When it wants to influence economic activity, the Fed buys or sells these assets through its Federal Open Market Committee (FOMC) or open-market desk, as it is commonly known.

b)For each of the listed independent scenarios specify the OMO action -- buy bonds or sell bonds -- would be appropriate and consistent with the FED\'s macroeconomic goals. Be sure to justify your specified action for each scenario: a) The unemployment rate is at an all-time high, and real GDP has fallen for two consecutive quarters;

FED should sell bonds so that purchasing power can be taken back from general public and AD can be reduced.

b) Real GDP is at a new peak and the unemployment rate is below the full employment rate, and the CPI has begun to increase above the maximum set by the FED.;

It should buy bonds so that purchasing power can be increased and can be increased in the hands of general public so that AD increases and economy bounces back to full employment equilibrium.

c) The unemployment rate includes 4% of cyclical unemployment, the real GDP is growing at 2% per annum, and financial institutions are not lending money.

It should buy bonds because unemployment rate is more than growth rate of GDP.

It should buy bonds so that purchasing power can be increased and can be increased in the hands of general public so that AD increases and economy bounces back to full employment equilibrium.