Define monetary base. Describe and discuss the methods that the Federal Reserve uses to control the monetary base.
The correct answer and explanation is:
The monetary base, also known as high-powered money, is the sum of a country’s currency in circulation and the reserves held by commercial banks at the central bank. In the United States, the monetary base consists of two components: currency in circulation (the physical money, including coins and paper bills) and bank reserves (the deposits that commercial banks hold at the Federal Reserve). The monetary base is an essential tool in controlling the money supply and influencing the broader economy.
Methods the Federal Reserve Uses to Control the Monetary Base
- Open Market Operations (OMOs):
The Federal Reserve’s most commonly used tool for controlling the monetary base is open market operations, where it buys and sells government securities (such as Treasury bills) in the open market. When the Federal Reserve buys securities, it credits the accounts of commercial banks with reserves, increasing the monetary base. Conversely, when the Fed sells securities, it removes reserves from the banking system, decreasing the monetary base. This operation helps control the amount of reserves available to banks, which influences the overall money supply. - Discount Rate:
The discount rate is the interest rate charged by the Federal Reserve to commercial banks for borrowing reserves. A higher discount rate makes borrowing more expensive for banks, reducing the amount of reserves in the banking system and, consequently, decreasing the monetary base. A lower discount rate encourages borrowing, which increases the reserves in the banking system and expands the monetary base. - Reserve Requirements:
The reserve requirement is the percentage of deposits that commercial banks must hold in reserve, either as cash or as deposits at the Federal Reserve. By increasing the reserve requirement, the Fed can reduce the amount of money available for lending, thus decreasing the monetary base. Lowering the reserve requirement increases the amount of money available for lending, expanding the monetary base.
These tools give the Federal Reserve the ability to influence the monetary base, which in turn affects interest rates, inflation, and overall economic activity. By carefully managing the monetary base, the Fed can pursue its objectives of price stability, full employment, and moderate long-term interest rates.