Question

Define monetary policy. List five monetary policy instruments used in the United States.

Answer 1

Monetary policy is central bank's actions and communications that manages money supply ranging from cash to credit in the economy.

Below are the 5 monetary policy instruments used by Fed in the United States.

1. Discount rate - This is the interest rate Fed charges commercial banks for short term loans. In order to expand money supply Fed lowers discount rate to encourage lending and to restrict money supply it increases the discount rate.

2. Reserve requirements - Fed decides the required ratio of deposits which bank must hold as reserve. An increase in reserve requirement is contractionary in nature while a decrease in reserve requirement is expansionary one.

3. Open Market Operations - Through buying and selling securities in the open market Fed tries to contol money supply in the economy. Buying of securities is expansionary in nature while selling of securities is contractionary one.

4. Interest on excess reserves - Usually banks keeps excess reserve with Fed than the required reserves. Fed also pays interest on such reserve. Therefore to encourage lending Fed lowers this interest rate and vice versa.

5. Inflation targeting - This will allow Fed to target a particular rate of inflation and ensure in the economy that current consumption is better for the economy and the effect will be expansionary in nature.

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