Question

1. 1.
   1. What are the four tools of monetary policy?
   2. Draw a diagram of the Federal Funds market and show changes as a result of the following. (draw separate diagrams for each of these cases).
      1. Fed lowers the discount rate
      2. Fed raises the interest rate on excess reserves
      3. Fed raises the required reserve ratio
      4. The demand for federal funds shifts to the right
      5. The demand for federal funds shifts to the left
   3. What type of defensive open market operations has to be undertaken in the above cases (iv) and (v).

Answer 1

ANSWER-1)

The tools that are used by the central bank under monetary policies to alter the money supply include the reserve requirements, discount rate, open market operations and the interest on reserves.

--Reserve requirements refers to the portions of deposits that banks are required to hold in cash, either in their vaults or on deposit at a Reserve Bank. A fall in reserve requirements is expansionary because it raises the funds available in the banking system to lend to consumers and businesses. A hike in reserve requirements is contractionary because it decreases the funds available in the banking system to lend to consumers and businesses.

-- Discount rate refers to the interest rate that the Reserve Banks charge commercial banks for short-term loans. Lowering the discount rate is expansionary because it influences other interest rates. The lower rates will encourage lending and spending by consumers and businesses. In similar way, raising the discount rate is contractionary because the discount rate influences other interest rates. The higher rates will discourage lending and spending by consumers and businesses

--Open market operations (OMO) refers to the buying and selling of government securities in the open market for the purpose of expansion or contraction of the amount of money in the banking system, facilitated by the Federal Reserve (Fed). In the US the Federal Reserve when a central bank is interested in giving stimulus to the economy by increasing the money supply then, it purchases government bonds from commercial banks and the public. On contrary, when the central bank is interested in controlling inflation, it sells government bonds to the public and commercial banks.

-- Interest on reserves: When FOMC want to create a higher incentive for banks to lend their excess reserves, it can reduce the rate of interest it pays on excess reserves. Consequently the banks tend to lend money instead to hold it in reserve thus resulting to an expansionary policy. In a similar way, if FOMC want to reduce the bank's incentive to hold more excess reserves, it reduce the lending by increasing the interest rate paid on reserves, and leading to a contractionary policy

As per policy we have to answer first question