Question

Explain the use of the tools of monetary policy in constructing an expansionary policy and describe under what economic conditions you think it should be employed? What will the desired outcomes be?

Answer the same questions with regard to a tight or contractionary money policy. Which do you feel is more effective an expansionary or contractionary policies? Explain.

Answer 1

Expansionary Monetary Policy

When the economy is in a sharp slowdown or recession, policymakers pursue expansionary monetary policy. The expansionary monetary policy includes the following -

1. Open market purchase of bonds

2. Lowering of discount rate

3. Reducing the reserve requirement

The federal reserve uses the open market purchase of bonds as the most common tool to pursue expansionary monetary policy. When the federal reserve purchases bonds from the open market, the banks and financial institutions sell bonds and are infused with cash. As cash and hence excess reserve in the banking system increases, the overnight lending rate among banks (federal fund rate) declines. This translates into lower interest rates for businesses and consumers.

When interest rates are low, businesses and consumers are more willing to pursue leveraged investment and consumption spending. As consumption spending increases, it encourages investment spending and this triggers higher GDP growth and relatively higher price levels in the economy.

Contractionary Monetary Policy

The federal reserve pursues contractionary monetary policy when the economy is in an inflationary boom and inflation needs to be curbed. The contractionary monetary policy tools with the federal reserve include the following -

1. Sale of bonds in open market

2. Increase in discount rate

2. Increase in reserve requirement

Again, the most commonly used tool by the federal reserve is sale of bonds in the open market. When the federal reserve sells bonds, banks and financial institutions are the buyers. This implies that liquidity is absorbed by the federal reserve from the banking system. When liquidity declines, excess reserves with the banks also declines and this translates into higher overnight lending rate (federal fund rate) among banks. The banks pass the higher cost of funds to the consumers and business and interest rates increase in the economy.

At higher interest rates (cost of money), businesses and consumers are less willing to pursue leveraged investment and consumption spending. This results in relatively lower economic activity and decline in price levels.

The Effective Policy

This can be best explained with an example and a more effective policy is expansionary monetary policy. To elaborate, the federal fund rate was at 1% in 2004 and the federal reserve started increasing interest rates ( contractionary monetary policy ) from 2004 to 2007. However, during this period, the banks had slack lending standards and even as the federal reserve tightened monetary policy, credit growth accelerated in the economy. This translated into a housing bubble and a stock market bubble even as the federal reserve attempted to pursue tight policies. Therefore, the banking system, under fractional reserve banking, can create money and this renders contractionary monetary policy ineffective even as the central bank tries to tighten liquidity.