Question

Explain the three major tools of monetary policy. Discuss how each is used in terms of stages of the business cycle-- specifically in the expansion and recession phases?

Answer 1

The three instruments of monetary policy are:

1. Open market operations- the buying and selling of securities in the open market to affect bank reserves.
2. The discount window policy – The discount policy is a facility wherein banks and primary dealers can borrow from the fund at the interest rate or discount rate.
3. Reserve requirements policy – this policy relates to setting the reserve ratio requirement that banks should maintain with the Fed.

An expansionary monetary policy is followed during recession ( when the economy is in decline, GDP falls). An expansionary monetary policy increases money supply.

The Fed buys securities from the open market, this will increase the money supply. Banks will lend more as lending rates will decrease. Consumer spending will increase.

The Fed will decrease the discount rate making it making it cheaper for banks to borrow.

The reserve requirements will lowered to increase money supply.

A contractionary monetary policy ( reduce money supply) will sell securities in the open market, raise the discount rate and raise reserve requirements.