Question

Explain how the Federal Reserve System will use three of their major tools to correct the macroeconomy in times of depression.

Answer 1

When there is a depression in the economy economic activity is reduced. this implies that there should be an encouragement given to the aggregate demand so as to stimulate the economy.

Central Bank or the federal reserve system can influence the economic activity using its monetary policy tools. The first one is a reserve requirements. These can be loosened in the form of decrease required reserve ratio.

When the required reserve ratio is reduced banks are allowed to to keep only a smaller portion of the deposits as reserves. They can generate more loans which will increase borrowings by reducing the rate of interest. This will increase the aggregate demand by increasing investment in consumption spending. The aggregate demand is increased and therefore real GDP is also increased

Another tool is the discount rate. When it is reduced, commercial banks can borrow from the federal reserve at a lower rate of interest which will increase their reserves and they can generate more loans. Once again the rate of interest is reduced and the money supply is increased. This will again increase the consumption and investment and thereby increase the real GDP.

Open market operations are the most important and frequently used monetary policy tool. when the central bank purchases government securities in the open market it infuses liquidity in the market. This is the reserves available at banks and once again through the same route, borrowings are increased with reduced rate of interest. This increases investment and consumption activities and therefore increase the real GDP.

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