Question

1. What tool does the U.S. Federal Reserve use to conduct policy? Explain. How does monetary policy impact the macroeconomy?

2. Explain financial Friction (use equation to explain) ? What are the mechanics of lowering interest rates?

3. Using AS/AD version of the short-run model, analyze the following macroeconomics event:

a- An inflation shock- Increase in price of oil

b- Disinflation- Reduce the Target Inflation

c- A positive aggregate demand shock – for example increase in demand for US goods.

Answer 1

Answer to Question 1)

The Federal Reserve in the United State of America was established in the year 1913, primarily with a view to provide stability to the economy and ensure that bank runs in which people would rush to the banks to withdraw their money all at once did not cripple the economy of the nation.

The Federal Reserve uses three policy measures or tools that impact the Monetary Policy which it creates. This creation has a large effect on the level of money in circulation the following is the explanation of the same.

1) Capital Reserve Requirements or Cash Reserve Ratio: -

For any commercial bank, it is mandatory for them, to keep a part of their deposits safe with the Federal Bank. This is to ensure that the money being deposited is not utilized at once, and the banks have sufficient capital when required in emergency situations.

The Monetary Policy aims at correcting the cash reserve ratio requirements. During a recession, the currency in circulation for an example is low. The Federal Bank reduces the cash reserve ratio requirements this in turns mean that banks then have higher working capital which is given away as loans and the currency in circulation in the economy is more. As a reason of this, the economy stabilizes and the recession gap is overturned. The exact opposite takes place when there is inflation in the economy respectively.

2) Open Market Operations: -

Open Market operations include selling and buying of bonds by the commercial banks. Whenever the economy is in crisis such as the recent recession due to the Corona Virus Pandemic, The Federal Government purchases bonds from banks and other institutions that hold the same. As a result, the overall money in the economy is supplied through the purchase and the economy can stabilize. The exact opposite takes place in case of inflation. The Federal Reserve then begins buying bonds to reduce the flow of money in the economy.

3) Discount Rate: -

The third policy tool used by the Federal Reserve is the Discount rate. This is the rate at which the Federal Reserve provides loans to commercial banks and it can help in making sure that the economy remains stable. For example, during an inflation, the discount rate can be increased and the same allows for reduced flow of money in the economy as commercial banks in return also increase their interest rates. This causes the economy to reduce the aggregate demand which is the total demand for goods and services and return towards being normal.

Please feel free to ask your doubts in the comments section.