Question

There is a recession in USA. The Central Bank Governor wants to assist the government in getting the economy out of this recession. What should he do to fix this problem?

i) What policy tools are available to the central bank to combat the recession?
ii). Explain in which direction each of the tools of monetary policy have to change to combat the recession? iii). How will the central bank change these tools?
iiii) Explain how do changes in central bank monetary policy tools get transmitted to AD - {Hint use the AD equation) and eventually to fixing the recession.

2: Discuss monetary vs interest rate targeting?

3: What's the money multiplier? Explain this concept verbally first and then using an example with numbers.

Answer 1

1.

The U.S. central bank, the Federal Reserve, has a dual mandate: to work to achieve low unemployment and to maintain stable prices throughout the economy. During a recession, unemployment rises, and prices sometimes fall in a process known as deflation. The Fed, in the case of steep economic downturns, may take dramatic steps to suppress unemployment and bolster prices both to fulfill its traditional mandate and also to provide emergency support to the U.S. financial system and economy.

 

i.  The reserve requirement refers to the money banks must keep on hand overnight. They can either keep the reserve in their vaults or at the central bank. A low reserve requirement allows banks to lend more of their deposits. It's expansionary because it creates credit. 

 

ii.  The goal is to keep the economy humming along at a rate that is neither too hot nor too cold. The central bank may force up interest rates on borrowing in order to discourage spending or force down interest rates to inspire more borrowing and spending.

 

iii.  Merely printing more money doesn’t affect the economic output or production levels, so the money itself becomes less valuable. Since this can cause inflation.

 

iv. Central banks also have a tool to smooth the business cycle: monetary policy. Most central banks have a dual mandate to maintain stable prices and to promote full employment. Central banks use the money supply to meet these two objectives. When a central bank changes the money supply, it changes interest rates, and changes in interest rates impact investment and aggregate demand.

2.

Also known as an operating target, a target rate is a key interest rate in an economy that the central bank uses to guide and gauge the effectiveness of its monetary policy. The target rate is an intermediate target that the bank can directly influence by its monetary policy and which it understands to be related to downstream economic performance.

A target rate is a key interest rate that a central bank uses to guide monetary policy toward the desired economic outcomes.

 

A central bank can choose its target based on official discretion or specific policy rules with the intent of influencing economic variables, such as employment or inflation. 

 

The Federal Open Market Committee generally uses the overnight fed funds rate as its target rate.

 

3.

The multiplier effect can be seen in several different types of scenarios and used by a variety of different analysts when analyzing and estimating expectations for new capital investments.

 

For example, when looking at a national economy overall, the multiplier would be the change in real GDP divided by the change in investments, government spending, changes in income brought about by changes in disposable income through tax policy, or changes in investment spending resulting from monetary policy via changes in interest rates.

1. The U.S. central bank, the Federal Reserve, has a dual mandate: to work to achieve low unemployment and to maintain stable prices throughout the economy.