Question

What is monetary policy? Who controls Monetary Policy? Provide an example when the Federal Reserve might use an expansionary policy ( increase the money supply). What three tools will they use and HOW would they use them to achieve their goal? For example, one tool that they could use is to reduce the reserve ratio.

Provide an example of when the Federal Reserve might use a tight monetary policy (decrease the money supply). Explain how they might use the three monetary tools.  

Which is the most popular tool that the Federal Reserve uses and why?

Answer 1

Monetary policy is the tool used by the Federal reserve to increase or decrease the money supply in the economy. It is controlled by the Federal reserve.

The Fed will use an Expansionary policy when the economy is going through a recession.In recession,the employment is high,real output is low and the aggregate expenditure is low.To improve the condition,the Fed will lower the federal funds rate,lower the reserve requirement and buy government securities in the market. This will increase the money supply in the economy and increase the availability of money with the banks.As money supply increase,the banks interest rate decreases so there will be more supply of loans which will increase the aggregate expenditure and increase th real output as the firms will hire more workers to meet the increase in demand.

The Fed will use a Contractionary policy to decrease the money supply when the economy is going through an inflation.Inflation increases the price level of the goods.To control the inflation,the Fed will increase the reserve requirement,sell government securities and increase the federal funds rate which will decrease the money supply in the economy.As money supply decreases,the interest rate increases,the banks make fewer loans and investments falls so the aggregate expenditure decreases which decreases the real output and so the price level falls.

The most important tool that the Fed uses is open market operations where it purchase and sells government securities.It is most widely used tool by the government as it allows the Fed to control the reserves held by the commercial banks and change the interest rates easily.