Question

  Monetary Policy to the Rescue: (20 pts.) – Answer in one long paragraph.

a) What actions would the Federal Reserve Board normally take to boost a weak economy (terms to use: open market operations, federal funds rate, liquidity, reserve requirement)? How would these actions be shown on a money market graph with interest rates on the vertical axis and the quantity of money on the horizontal?

b) In addition to these traditional steps to help the economy, the Fed is also buying massive amounts of bonds, lending directly to banks, supporting loans to businesses,  loaning money to state and local governments, and relaxing regulatory requirements.  What are the Fed’s goals in doing this, and what effect is it likely to have on credit markets and consumer and business spending?

c) Why do many experts believe that the recent lowering of the federal funds rate will not have a large effect on economic activity?

Answer 1

Fed is entrusted for conducting the monetary policy. In order to stimulate the economy the Fed will have to conduct an expansionary monetary policy. Expansionary monetary policy aims to increase Money supply in the economy.The implementation of such a policy implies changing the instruments of monetary policy in the following way.

*open market operations

Open market operations refers to the buying and selling of security. In order to boost the economy, money must be transferred into the hands of people. So Fed buys securities and provides people with money.

*Federal funds rate

Federal funds rate is the rate interest rate banks charge each other to lend Federal Reserve Funds overnight

Federal funds rate will be lowered so that borrowing becomes less costly.

* Reserve requirements

These are the amount of funds bank holds in reserve to ensure that it is able to meet liabilities in case of a sudden crisis.

Fed will lower the reserve requirements so that banks have more money and credit creation is increased.

* since economy is going through a recession, liquidity also must be increased.Fed will have to provide massive liquidity injections to calm markets amid signs of stress.

These actions can be shown on a money market graph as follows.

b) Fed adopts measures stated above in order to bring the economy out of recession.

* The measures like reducing reserve requirements will increase the amount of money available with banks as excess reserves, these excess reserves will be used for the purpose of credit creation. Availability of credit will increase in the economy.

* The measures like lowering discount rates, federal funds rate etc makes borrowing cheap. When borrowing becomes cheaper, consumption and investment activities based on borrowing will increase.

* Lending to governments will stimulate government expenditure. Government's social security measures will help in rising the consumption of disadvantaged sections. Government's spending in infrastructure development will attract more investment.

*with increase in its components, aggregate demand will rise which ultimately stimulates production. All the incentives will contribute to it.

* Eventually, the economy will be back on track

c) However many experts believe that lowering federal funds rate won't have much impact.They focus on the following aspects

* Stock market will be affected by the move.ln fact, US stock markets futures will be the worst hit ( we saw this becoming reality when the rates cut was announced. stock market futures hit 5%)

* The federal funds rate cut also leads to the slow down of GDP growth.

* The monetary transmission mechanism will be weakened

*such cuts have already been implemented. After almost a decade of extremely low rates, there aren't many consumers with pent-up demand expecting an interest rate fall.

Most importantly, lower interest rates may leads to liquidity trap. Liquidity trap happens when interest rates are so low that they don't serve the normal function of spurring the economic growth.