Question

- Describe the monetary policy tools the Fed can use to affect the monetary base.

- Compare and contrast expansionary and contractionary monetary policies.

Answer 1

A.

The tools the Federal Reserve uses in Monetary Policy are -

1. Federal Funds Rate - The federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight on an uncollateralized basis. A committee of the Federal Reserve sets a target federal funds rate eight times a year, based on prevailing economic conditions.

2. Open market Operations - The Federal Reserve purchases and sells U.S. Treasury securities in the open market in order to change the money supply in banking system. It purchases Treasury securities to increase the supply of money and sells them to reduce the supply of money. It therefore changes the availability of loan to businesses and consumers. The Fed mostly uses Open Market Operations to arrive at target range of Fed funds rate.

3. Changing Reserve Requirements - Reserve requirement is a tool used by the Federal Reserve to increase or decrease money supply in the economy by changing reserves that banks need to hold at Federal Reserve. Reserve requirements are the amount of funds that a bank holds in reserve to ensure that it is able to meet short term liabilities on deposits.

4. Discount rate – The discount window is used to lend money to banks to meet the reserve requirement. The Fed's discount rate is usually higher than the fed funds rate. Banks use the discount window only when they are not able to get overnight loans from other banks

5. Repos – Repo also known as Repurchase Agreement is a tool that fed used to lend money to banks on collateralized basis. Here the Fed lend banks money and accepts securities usually in the form of treasury securities from Banks. The loans are overnight as well as term basis.

B.

Expansionary Monetary Policy                       

When a central bank uses its tools to stimulate the economy with increasing money supply, the policy is said to be Expansionary Monetary Policy. It lowers interest rates and increases money supply to increases aggregate demand and boosts GDP. The Fed's most commonly uses open market operations to increase money supply in banking system. It buys Treasury securities from the banks and lend money in form of excess reserves. This excess reserves the bank can lend to the consumers and businesses to expand economic activity. Other tools like decreasing Federal Funds rate which makes borrowing overnight from banks cheaper, reducing reserve requirements are also used in conjunction with OMO’s. The Expansionary monetary policy is used when the economy is running below potential GDP and there is spare capacity. The Fed aims to fill that recessionary gap (Real GDP is below Potential GDP) with its expansionary monetary policy so as it can achieve target Economic growth with price stability and low unemployment.

Contractionary Monetary Policy

Contractionary monetary policy is used to fight inflation by decreasing the money supply and in result increase the cost of borrowing which in turn decreases GDP and eases inflation. When the economy is running above Potential GDP, the inflation rises much faster and reduces the purchasing power of the currency. The Fed aim to maintain the price stability by targeting 2 % mandated target. When economy is in inflationary Gap (Real GDP is higher than Long run Potential GDP), the fed raises the Federal Funds rate to reduce inflation. It also conduct OMO’s (Open Market Operations) by selling treasury securities to banks with increasing reserve requirement ratio, thus squeeze out excess reserves from banking system. This in turn reduces the money supply that banks can create with multiplier effect and less money supply results in higher interest rates charged by banks to customers. In contractionary Monetary Policy the Fed tightens the money supply by using its all tools in its arsenal to bring back the inflation to its 2 % target.