Question

What are the three (3) tools available to the Federal Reserve in their conduct of monetary policy? The economic growth rate of the economy is low and there is a higher than normal unemployment rate. How would the Federal Reserve adjust their policy tools to return the economy to full employment?

Answer 1

The three tools available to the Federal reserve for conducting the monetary policy are:-

- open market operation

- discount rate

- Reserve requirement

When the economy is going through recession and unemployment is high then the Fed will conduct the expansionary monetary policy where it would purchase government securities in the open market, lower the discount rate and the reserve requirement, all of which will increase the money supply in the market.

As money supply increases, the banks lend more loans at a lower interest rate which will increase the disposable income with the public which in turn increases the aggregate demand.

As AD increases, the firms will invest more and produce more which will increase the demand for labor so the unemployment decreases.

As firms output increases, the real GDP increases which bring the economy out of recession and shifts the AD curve to the right to the full employment level.