Question

1. Why do people hold money?

What are the tools of monetary policy and how can the Federal Reserve apply these in a recessionary environment?

Answer 1

According to Keynesian liquidity preference theory, people hold money for mainly three reasons.

1. Transaction motive- People like to hold money for day to day transactions to keep up with daily expenses.
2. Precautionary motive- People tend to hold money as security against unforeseen events.
3. Speculative Motive- People tend to hold more money due to this motive which depends on the rate of interest and expectations.

The tools of the monetary policy of Federal Reserve are:

• Open market Operations- Buying and selling of government securities in open market.
• Discount Rate- The Interest rate at which Federal Reserve gives loans to commerical banks.
• The required Reserve Ratio- The Percentage of total deposits which commercial banks must hold as Reserves

In a recessionary environment Federal Reserve will conduct open market purchase of government securities to increase money supply.

In the recessionary environment Federal Reserve well reduce the discount rate so that commercial banks can provide loans for the at lower interest rates.

In the recessionary environment Federal Reserve will decrease the required reserve ratio so that the commercial banks can expand their credit.