AP Macroeconomics : How to find the effect of bonds on money supply
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Example Question #1 : Money Supply
If the Federal Reserve is trying to head off a recession, which of the following is the most likely action that it will take?
Buy bonds via open market operations.
Decrease the reserve requirement for banks.
Cut taxes in order to increase aggregate demand.
Increase government spending in order to increase aggregate demand.
Increase the discount rate.
Buy bonds via open market operations.
The correct answer is that the Federal Reserve would be most likely to buy bonds via open market operations.
Here's why: The most common tool that the Federal Reserve uses to manage recessions is to expand the monetary supply, which makes it cheaper for businesses to borrow money and make capital expenditures, which has a net effect of increasing aggregate demand. In order to increase the money supply, the Federal Reserve buys bonds on the open market (and pays cash for these bonds). The cash that the Federal Reserve pays for these bonds expands the money supply, which has the net effect of decreasing interest rates.
If you understand the theory behind this, but answered "Decrease the Reserve Requirement for Banks", pat yourself on the back - you most likely understand the theory behind the Federal Reserve quite well. However, this is still not a correct answer - the reason is that the question was what would the Federal Reserve be most likely to do. Decreasing Reserve Requirements is a major move by the Federal Reserve, and the Federal Reserve would be much less likely to adjust Reserve Requirements than to adjust interest rates via open market operations.
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