Question

-List and Describe the four tools of Monetary Policy.

-How specifically do the four tools affect the Aggregate demand curve and the economy?

Describe the methods used and conditions under which contractionary and expansionary policies would be implemented.

Thank you.

Answer 1

The Fed can use four tools to achieve its monetary policy goals: the discount rate, reserve requirements, open market operations, and interest on reserves.

The discount rate is the interest rate on short-term loans that Reserve Banks offer to commercial banks. Federal Reserve discount-rate lending complements open market operations in reaching the federal funds target rate and acts as a source of liquidity for commercial banks to back up. Lowering the discount rate is broad, since certain interest rates are affected by the discount rate. Lower rates encourage lending and spending by consumers and businesses. The increase in the discount rate is also contractionary, as the discount rate affects other interest rates

Reserve requirements are the portions of reserves that banks are expected to keep in cash, either in their vaults or on a reserve bank account. A reduction in reserve requirements is expansionary as it increases the funds available for lending to customers and companies within the banking system. An rise in reserve requirements is contractionary, as it decreases the funds available for lending to customers and companies in the banking system. The Board of Governors has sole authority over changes to reserve requirements. The Fed's criteria for reserves rarely change.

Open market operations , the acquisition and selling of U.S. government securities, is a effective tool. As we heard earlier, this resource is regulated by the FOMC and run by New York's Federal Reserve Bank.

Interest on Reserves is the newest and most commonly used instrument provided by Congress to the Fed after the 2007-2009 financial crisis. Reserve interest is paid out on surplus funds held at Reserve Banks. Remember that Banks are mandated by the Fed to keep a percentage of their reserve deposits. In addition to these reserves banks also retain additional reserve funds. The new policy of paying interest on reserves enables the Fed to use interest to manipulate bank lending as a monetary policy tool. For instance, if the FOMC decided to create a greater incentive for banks to lend their excess reserves, it would lower the interest rate on excess reserves that it charges.

The amount of consumer expenditure, government spending, production, and net exports is aggregate demand (AD). The AD curve assumes there is fixed money supply.
The decline in the money supply is followed by an equivalent drop in nominal production, better known as GDP. The decrease in the money supply would lead to a drop in consumer spending. This lowering will move the AD curve to the left. An equivalent increase in nominal output, or Gross Domestic Product (GDP), is reflected in the rise in money supply. The rise in money supply would result in increased consumer spending. This rise would have the AD curve moved to the right.

Fiscal policy is the use of government spending and tax policies to control the economy's trajectory over time. Automatic stabilizers, which we heard about in the last section, are a passive form of fiscal policy, because Congress does not need to take any further action once the mechanism is developed. On the other hand, discretionary fiscal policy is an aggressive monetary policy using expansive or contractionary policies to speed up or slow down the economy. Expansionary fiscal policy comes about when Congress acts to cut tax rates or increase government spending, moving the aggregate demand curve to the right. Contractionary fiscal policy occurs when Congress raises tax rates or cuts government spending, shifting aggregate demand to the left.