Question

The economy's unemployment rate has risen 5% above the natural rate (full employment). The Federal Reserve has been asked to utilize one of their monetary policy tools to assist in stabilizing the economy (reduce unemployment). a)What is the most effective FED tool to use in this particular situation? b)Explain what the effect would be on the reserves of the bank as a result of implementing your choice. c) Would this be expansionary monetary policy or contractionary monetary policy?

Answer 1

a)When the economy faces recession or involuntary cyclical unemployment,as a result of fall in aggregate demand, the Fed has to take action  to bring the economy out from  such a situation.The Fed tries to increase the money supply in the economy by lowering the interest rate so that aggregate demand increases in the economy and stimulates the economy.The three monetary policy measures adopted during recession are open market operations ie buying securities in the open market which will increase the bank reserves and the banks can give more loans to investors ,lower the discount rate so that the banks can borrow more from the Fed and give loans to investors,reduce cash reserve ratio that is the amount of cash banks have to keep with Fed and thus give more loans to investors.

b)When the Fed buys securities from the public or from the commercial banks , the reserves of the banks increases.Again with less CRR and lower discount rate ,more credit will be available with the banks. With the increased reserves , the banks can give more loans to investors and businesses for investment.More investment will shift the aggregate demand curve upward and there will be expansionary effect in the economy.

c) This is expansionary monetary policy. The expansion of credit or money supply in the economy will increase investment.When credit increases and investment increases in the economy,there will be expansionary effect on output and employment.