Economics Questions!!?

Question

1). What might happen in an economy if the central bank fails to supply the "right" amount of money to the economy?

2). The Federal Reserve uses a tool called "open market operations." Describe this tool. How can teh Fed use open market operations to influence economic activity?

Answer 1

Ok, here is how I would answer these questions.
1. If the central bank fails to supply the "right" amount of money to the economy, there are several things that can happen. If it supplies too little money, deflation will result. This actually occurred in 1929 with the Great Depression, which resulted largely from the Federal Reserve selling a large portion of the securities that it held and contracting the money supply by nearly half. This in turn lead to banks not having enough money to meet their depositors demands, which led to bank runs and the closing of many financial institutions. The Federal Reserve's failure to supply enough money had ripples throughout the entire economy and caused the Great Depression.
If the central bank supplies too much money, then inflation will result. Since there is more money in circulation, it will be lent more easily, and economic growth will likely result. However, it may begin to grow at an unsustainable pace, which will eventually result in a severe cooling that will be similar to a depression. For this reason, the central bank does its best to keep inflation and hyper growth of the economy in check.

2. The Federal Reserve uses a tool called "open market operations" to conduct monetary policy. The procedure for "open market operations" is as follows:
The Federal Open Markets Committee (FOMC) decides to either lower or raise the interest rate in response to the inflationary and growth pressures in the economy. Once a course of action is decided upon, a call is made to the New York Federal Reserve, where the transaction is put into effect. If the interest rate is raised, the Fed sells some of its securities, thus reducing the amount of money in circulation and making it harder to borrow. Remember, the interest rate is the price of money, since it is what it cost to borrow money for use today. If the interest rate is lowered, then the Fed buys some of the governments securities, thus increasing the money supply.
When the Fed buys or sells government securities, it pays or takes the money out of the Banks reserves account. Thus, the total reserves of the nation are either increased or reduced, and due to the money multiplier based upon the reserve ratio, the money supply is increased or reduced by more than the amount that was done to the reserves.
Bottom line, by changing the money supply, the Fed can either make it easier to borrow and thus spur the economy, or make it harder to borrow by making less money available, slowing the economy but also curbing inflation.

Answer 2

For your first question the answer is that you can have detrimental effects on the Economy. If there is too much money in the Economy you have Inflation. In some cases before Milton Friedman helped to show the correlation (not causation) between inflation and money supply, it was common practice for a central bank to print more money to keep up with inflation. This lead to Hyper Inflation. A good example of this is post WW1 Germany. If they do not provide enough money you can end up with deflation and stifle economic growth.

The Open Market operations in short refers to the Federal reserve's principal tool for monetary policy implimentation that being the sale of US Treasury and Federal Agency Securities. By selling these securities at a given rate of interest the Fed. Res. decreases money supply by removing money from the money market. This helps to control inflation. The selling and buying of these Securities can adjust the opportunity cost of investment and expenditure of business and the public and in doing so influence economic activity.