Question

6.Monetary Policy

a.How can open market operations be used by the Fed to increase or decrease reserves in the banking system?

b.What happens to bank lending and to interest rates when the Fed increases reserves in the banking system?

c.Using your answer to part b, explain why Federal Reserve’s efforts to increase the money supply would be termed expansionary.

d.Why would the Fed’s efforts to decrease the money supply be considered contractionary?

Answer 1

6. a) open market operations refers to the selling and buying of government securities to the public. When Fed purchases securities, the reserves in the banking sector falls and more money is pumped in the economy. Similarly, when Fed sells the securities, it increases the reserves in banking system. Money supply reduces.

b) Fed increases the reserves in banking system by adopting contractionary monetary policy. This leads to a fall in money supply. Banks will have fewer funds to lend which in turn would increase the interest rate.

c) Federal Reserve's effort to increase the money supply is termed as expansionary because the economy expands or grows when money supply is increased. As money supply increases, interest rate falls which induces people to borrow and make investments. Thus, the economy expands.

d) Fed's effort to decrease the money supply is termed as contractionary because the economy contracts or shrinks when money supply is decreased. As money supply decreases, interest rate rises and so people hesitate to borrow. This leads to a fall in investments. Thus, the economy contracts.