Quiz 14: The Fiscal Policy Dilemma


Federal reserve, commonly known as fed is the central bank of country U. The responsibility of this institutions is to develop and implement monetary policy for the country. It regulates the money supply and manipulates the interest rates as well. When fed performs open market operations then they sell or buy bonds in the open market. If fed buys the bonds then the money fed paid gets deposited in banks and then first ripple happens which is the change in amount of reserve with the banks. Next ripple would be that bank would like to dispose off their excess reserves and to do so they give more

Financial institutions are part of financial system of an economy, financial intermediary and depository institutions like banks, credit unions, etc. are part of it. Money is the most widely accepted medium of exchange Economy and financial Institutions of any country are evolving with time that are working today. They will become ineffective with time because the number of substitute available for financial institutions will increase and the relationship between money supply and inflation is going to change because of the developing market conditions and the understanding of the people. These changes will change the need of Central Bank with time. It can be seen from the Federal Reserve history that policies and theories implemented today are very different that they were being used a hundred years back.

The expenditure multiplier given as 3 and to increase the income by $240, the investment should increase by $80. There is an inverse relationship between the interest rate and the investment. Further it is given that to increase the investment by $20, the interest rate drops by 1 percent. This also implies, to increase investment by $80, the interest rate must drop by 4 percent. A change in money supply results in bringing desirable changes in the interest rate. It is given that each of $5 change in money supply will change the interest rate by 1 percent. Thus, to change the interest rate by 4 percent, the money supply should change by $20 (applying simple unitary method). The mathematical relationship between the money supply, money multiplier and monetary base is as follows: img In the above equation, substituting the value money multiplier as 4 and money supply as $20, we get that the monetary base should increase by $5. Therefore, the suggested policy is open market purchase which results in an increase of monetary base by $5.