Question

1. Describe the 4 main tools of monetary policy that the Fed uses.
2. Describe the Fed’s main goals (in terms of monetary policy)
3. Explain and show how the money market (supply and demand for money) is used to find the equilibrium interest rate and how it is affected by changes in the money supply.  Show the diagram and explain the slope of money demand and illustrate what happens when the Fed increases or decreases the money supply.

Answer 1

1. Four main tools of monetary policy.

1. Bank Rate(discount rate) - It refers to the state at which the central(Fed) Bank lends money to commercial banks as the lender of the last resort. The Bank rate is announced by the central Bank at regular intervals in response to the needs of money market.

2. Open market operation = Open market operation refers to buying and selling of government securities by the Central bank from/to the public and commercial bank.

sale of securities by the Central bank to reduces the reserve of commercial banks. It adversely affects the bank's ability to create credit and therefore decrease the money supply in the economy.

Purchase of securities by central bank increase the reserves and raises the bank's ability to give credit.

3. Legal Reserve Requirements = According to Legal reserve requirement, commercial banks are obliged to maintain reserve. It is a very quick and direct method for controling the credit creating power of commercial banks.

4. Margin reqirements = Margin is the difference between the amount of loan and market value of security offered by the borrower against the laon. If the margin fixed by the Central bank is 40%, then commercial banks are allowed to give a loan only up to 60% of the value of security.

2. The Fed's main goals( in terms of monetary policy)

The main goal of Fed in terms of monetary policy are promote maximum employment, stable prices and moderate long term interest rates. In the monetary policy the central bank able to change the interest rate and money supply in the economy by using method of credit control. When there is inflation in the economy central bank increase the interest rate or reduces the money supply to maintain the employment, price and interest rates in the economy. In the same way when there is recession(deflation) in the economy central bank decreases the interest rate or increase the money supply to maintain the employment, price level and interest rates in the economy.

change in money.

4. The slope of money demand indicates that there is inverse relation between the interest rate and the quantity of money demanded. It means Higher the interest rate lower the money demand, and vice versa.

The increase and decrease in money supply show in the above diagram.