Question

What are the three monetary policy tools of the Fed? Briefly describe how each tool can be used to implement an expansionary monetary policy and a contractionary monetary policy.

Answer 1

The tools used by the Fed are :

• Discount rate
• Reserve requirement
• Open market operations

Discount rate: Is the rate that the Fed charges to lend money to banks. When the Fed lowers this rate, money is available to banks at a cheaper rate, as a result banks are able to lend more money at lower rates of interest.  So, when the Fed follows an Expansionary policy, it lowers the discount rate, more money is pumped into the economy. This leads to less savings and more spending. Increased spending fuels the economy, leading to lower unemployment.

When the Fed follows a contractionary policy, then the discount rate is increased. So, that borrowing by banks becomes expensive and less money in pumped into the system.As money is available at higher rates of interest.

Reserve requirement : is the amount of funds banks have to keep with the Fed as reserves. When the reserve requirement increases , then the banks have to keep more funds with the Fed as a result the economy is entering into a contractionary phase.

When the Fed relaxes the reserve requirement , then more money is available with the banks to lend. So, the economy is in a expansionary phase as the with more money available in the financial system , demand increases , output increases and unemployment decreases.

Open Market Operations: Is the policy of the Fed purchasing/selling securities from or to the banks. When the Fed purchases securities from the banks, money is pumped into the banking system , banks have more money to lend , there is more employment opportunities hence the economy enters into a expansionary phase.

When the Fed, sells securities to the banks, it reduces the money supply with the banks. The economy enters a contractionary phase.