Question

2. Explain the following:

A)

If economy is suffering from an inflation, what kind of monetary policy can be used to deal with the inflation? What are the monetary tools that can be used to conduct the monetary policy in this situation? Carefully explain.

B)

What is the basic objective of monetary policy? What are major strengths of monetary policy? Why is monetary policy easier to conduct than fiscal policy? Carefully explain.

Answer 1

a. The Fed has many instruments that it typically uses to enforce monetary policy that is contractional. It only does so if it fears that inflation gets out of control. The first line of defence is open operations on the sector. The Fed buys or sells securities from its member banks, which are usually Treasury notes. When it needs them to have more money to lend it buys securities. It sells those securities which are compelled to buy by the banks. That reduces their capital, giving them less to lend. As a result, they can charge higher interest rates. That slows economic growth and mops up inflation.

Second, the Reserve Requirement can be increased by the Fed. This is the amount banks are expected to keep in reserve at the end of each day. Raising this balance would keep money out of circulation.

Second, the Fed could increase the rate of the discount. That is the interest rate paid by the Fed to permit banks to borrow funds from the Fed's discount window.

Rarely does the Fed change those two devices. It typically adjusts the amount of fed funds, instead. To retain the Reserve requirement, it is the interest rate banks charge each other for loans that they make. This is much easier to adjust for the Fed. It has the same impact as changing requirement and discount rate for the Reserve.

b. Monetary policy goals The primary purposes of monetary policies are to combat inflation or unemployment, and to preserve currency exchange rates.

Monetary inflation policies will target inflation rates. A low level of inflation is seen as good for the economy. If inflation is strong, this can be resolved by a contractionary policy.

Unemployment Monetary policies can affect the level of economic unemployment. For example, an expansionary monetary policy usually reduces unemployment, as the higher supply of capital increases economic activities that contribute to job market expansion.

Inflation reduces the value of money by weakening its buying ability. As inflation increases higher than expected, the Fed will sell government bonds to increase short-term interest rates or take money out of circulation. According to San Francisco's Federal Reserve Bank, these acts will lead to long-term rate rises for banks and other lending institutions. This reduces credit availability and decreases consumer spending, reducing inflation. Short-run intervention helps policymakers to assess economic conditions and foster long-term sustainable growth and low inflation.

Monetary policy is usually carried out by independent monetary authorities. For instance, in the UK, monetary policy is enforced by the Bank of England's Monetary Policy Committee. Governments will also take politically controversial decisions such as rising interest rates in order to reduce inflationary pressure. It was a highly charged political decision, as governments set interest rates. For example, industry lobbying for rate cuts to prevent joblessness. Governments also will be tempted to cut interest rates prior to an election. Fiscal policy is about adjusting rates of taxes and spending. Deflationary fiscal policy, for example, may include cutting spending. Yet to support the macroeconomy, it is hard to find a department able to get its budget slashed. Spending cuts prove to be extremely controversial from a political viewpoint.