Question

Discuss at least 5 Federal Reserve policy actions. Indicate which direction would be expansionary and which contractionary. Make sure you include open market operations, their most useful tool.

Answer 1

Policy actions refers to the steps that the Federal Reserve takes in concern with the monetary policy of a state. The following actions are generally taken by the Federal reserve in maintaining and controlling the monetary policies

a) Discount rate: The discount rate refers to the interest rate that the Federal banks charges on the commercial banks for short-term loans. It complements the open market operations[discussed later] in achieving the target federal funds rate and serves as a backup source of liquidity for the commercial banks. Here, lowering the discount rate is considered to be an expansionist policy and raising the same is considered to be a contractionary one. Thus the higher rates discourages both lending and spending by the business and consumers

b) Reserve requirements: They are the portions of deposits that the bank must hold in cash either in their own vaults or at the Federal bank. Here, a decrease in the reserve requirement is considered to be expansionary as it is expected to increase the fund available to the banks which they lend to the customers and business. Thus increase in the reserve requirement is a contractionary process as it reduces the funds that are available to the banking system for lending

c) Open market operation: This refers to the buying and selling of the government securities in the market framework. This is considered to be the most reliable method of monetary policy. When the federal bank needs to increase the money supply in the economy, it purchases the government securities from the market and when it needs to suck out the liquidity, it would sell these securities. Thus buying of these securities are considered to be expansionary as it would increase the liquidity in an economy whereas selling them deceases the liquidity and is considered to be contractionary in nature.

d) Interest on reserves: It is the newest and frequently used tool bye the Federal reserve, especially after the Financial crisis of 2007-09. Here, the interests are paid on the excess reserves that the commercial banks keeps at the Federal reserve. This is in addition to the reserve that the banks should strictly keep at the Federal reserve. It allows the Federal reserve o use interest as a monetary policy tool to influence the lending of banks. When the interest rates are reduced by the Federal reserve on these, the banks are expected to lend more which leads to an expansionary policy. At the same time, in order to impact a contractionary policy, the Federal reserve would increase the interests on these reserves which forces the banks to lens less.

e) Unconventional tools and policy announcements: In addition to the standard expansionary and contractionary tools, during extreme economic crisis, the Federal reserve would load a lot of money in the treasury and introduce novel purchasing programmes combining the actions of discount lending, open market operations and quantitative easing. Moreover the Federal reserve may also resort to making public announcements of its future policy models which can in turn shape the market and makes it suitable for the reserve to take proper actions in the market