Question

10. What are the three monetary policy tools of the Fed? Briefly describe how each tool can be used to implement an expansionary monetary policy and a contractionary monetary policy.

Answer 1

The three monetary policy tools of the Fed are open market operations, the discount rate and reserve requirements. Open market operations refer to the buying and selling of government securities in the open market. Discount rate refers to the interest rate charged by Reserve Banks on short term loans lended to commercial banks. Reserve requirements refer to the portion of deposits that commercial banks should hold as cash either in their vaults or as reserves with Reserve Banks.

Inorder to implement an expansionary monetary policy discount rate and reserve requirements are lowered. When discount rate is reduced commercial banks can borrow more amount of funds at lower interest rates and this will induce them to reduce their rate of interest and people can now borrow money at lower interest rate and thereby increasing the money supply in the economy. When reserve requirements are lowered commercial banks need to keep only less proportion of their deposits as reserves and they can lend the rest of the amount. This will increase their fund available for lending and increases money supply. Incase of open market operations, buying of government securities is undertaken. When government securities are bought money flow into the hands of public and thus increasing the money supply.

For implementing a contractionary monetary policy discount rate and reserve requirements are increased and this reduces the lending activities of the commercial banks and thus reduce the money supply. Incase of open market operations government securities are sold and money flow from the hands of public to Federal Reserve Banks and reduces the money supply.