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The Federal Reserve has three primary tools for affecting the reserves of depository institutions:
the Reserve Requirement, Discount Rate and Open Market Operations.
Fiscal Policy is taxation, expenditures, and debt management by the federal government. It
may be used to purseue the economic goals of full employment, price stability and economic
growth. It also affects the supply of money and the capacity of the banking system to lend.
Deficit if the government expenditures exceed revenues, and this must be financed.
Surplus if government revenues exceeds the expenditures.
It is the financing of the deficit or disposing of the surplus that affect the supply of money and
capacity of the bank to lend.
If Federal government runs a deficit, it may obtain funds to finance by borrowing from the
following:
1. General public
o Federal government issues securities to finance deficit, if the general public
purchases the securities, funds are transferred from the general public to the
treasury. When the Treasury pays for goods and services, the public’s bank
deposits are restored as the mone is transferred from the Treasury’s account to
the general public’s account. No change in money supply and reserves because
there is no change in the demand deposits or cash.
2. Banks
o Financed by the banks – the banks buy the government securities. The money
supply expanded but the capacity of the banks to lend decreased because
excess reserves are reduced.
3. The Federal Reserve
o The federal reserve buys the securities, the treasury account at the Fed is
increased. The Treasury spends these funds and payment of the commercial
banks. The federal reserve transfers funds from Treasury to the banks account.
Effects on money supply and ability of the banks to lend:
i. Total demand deposits rise when the public makes deposits
ii. Total reserves of the banks increased.
4. Foreign Investors
o Securities are sold abroad, when funds of the sale are deposited in domestic
banks, the banks’ reserves are increased.
Inflation – a general increase in prices. Prices could also mean what produces must pay for the
plant and equipment, but when the word inflation is used, as the implication is that the prices of
consumer goods and services.
Deflation – General decline of prices. Lower prices aimply lower cost of goods sold and
increased profits for some individual firms. Lower prices, however, also imply decreased
revenues and profits for the other firm.
Recession – Period of atleast six months during which the economy experiences increased
unemployment and negative growth.