Question

Explain what is meant by monetary policy. List and explain the 3 tools the Federal Reserve has to conduct monetary policy. What is your opinion which is more effective fiscal or monetary policy? Explain why you feel the way you do.

Answer 1

(a) Monetary policy is the policy used by Central Banks to influence aggregate demand and/or interest rate, using money supply.

(b) The three primary monetary policy tools are:

(1) Open market operations

When Fed wants to increase (decrease) money supply, it conducts open market purchase (sale) of federal securities, which is an expansionary (contractionary) monetary policy.

(2) Required reserve ratio

When Fed wants to increase (decrease) money supply, it decreases (increases) required reserve ratio, which increases (decreases) banks' credit lending, which is an expansionary (contractionary) monetary policy.

(3) Federal funds rate/Bank rate

When Fed wants to increase (decrease) money supply, it decreases (increases) Federal funds rate, which increases (decreases) banks' credit lending, which is an expansionary (contractionary) monetary policy.

(c) In my opinion, fiscal policy is more effective, because while monetary policy effects last longer, the policy measures take longer to implement and impact the economy, compared to fiscal policy which acts faster even though its effect is relatively shorter in duration.