Federal Reserve open market operations and money supply control

Economics of Government Bonds

If the Federal Reserve wishes to use an open market transaction to reduce the money supply, it must sell government bonds. To determine how many, we consider the following formula:

DD = (1/RRR) * ? Reserves

The desired change in demand deposits is $100 billion. The required reserve ratio is 5%. Therefore, we derive the following formula for the amount that the Federal Reserve needs to change reserves:

Int Rate

As the price rises, the return on the bond diminishes. The bond that is priced today at $500 returns nothing to the holder for their time, but the bond that returns $125 over the year has a high rate of return.

12-5) This is not correct. When aggregate demand for money increases the interest rate, there will be a reduction in money demand, but the relationship between the two is not perfect. The decline in demand for money will not be sufficient to bring the interest rate back to equilibrium without assistance. The Fed must actively move to decrease the money supply in order to bring the interest rate back to equilibrium. The speaker is assuming that the demand for money is related only to interest rates, which is not the case. If that were the case the economy would always be in equilibrium, which is essentially the state described. The upward shift in demand would not occur at all. However, the upward shift in demand shows that there are other considerations at work in the economy, and thus the interest rate cannot be expected to respond to changes in demand for money perfectly. The Fed must intervene in order to maintain equilibrium.