6. An economy is facing a recessionary gap and the Federal Reserve decides to engage in...

6. An economy is facing a recessionary gap and the Federal Reserve decides to engage in expansionary monetary policy. What are the three tools that the Federal Reserve can use to get the money supply to grow and what direction should each take?

Solutions

Expert Solution

The federal reserve can use the following tools as a part of expansionary monetary policy

It can decrease the reserve requirement. depository institutions are required to keep a fixed fraction of their deposits as required reserves with the Fed. When this requirement is decreased this implies that banks are now equipped with additional reserves which can be used in generation of loans. This increases money supply and reduces the rate of interest. As a result investment demand increases and this increases aggregate.
Federal reserve can decrease the discount rate. This is the rate of interest charged on the loans provided by the federal reserve to depository institutions. Again when this is reduced depository institutions are encouraged to take more such loans and increase their reserves. Once again the money supply is increased and rate of interest is decreased. Investment and aggregate demand increase
federal reserve can engage in open market purchase of government securities which will help a depository institutions in increasing excess reserves. As the money supply is increased and rate of interest is reduced aggregate demand is increased.

Rahul Sunny answered 1 year ago

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