Question

Explain two ways by which the Federal Reserve System can increase the monetary base. Why is the effect of Federal Reserve actions on bank reserves less exact than the effect on the monetary base?

Answer 1

The Fed can increase the monetary base using one of these two tools:

1. Open-market operations: if the Fed wants to increase the money supply, it can buy government bonds. The money the Fed prints to buy these bonds increase the monetary base.
2. Reserve requirements: the Fed can increase the reserve-deposit ratio for commercial banks. In other words, commercial banks will have to keep more reserves as a percentage of the deposits they hold, and this increases the monetary base.