Question

List the four tools of monetary policy and briefly describe the usefulness and limitations of each

Answer 1

Four tools of monetary policy are the Discount rate, open market operation, reserve requirement, and the federal fund rate.

a) Discount rate helps correct the business cycle. The discount rate is the rate at which the federal bank lend funds to the other banks. If the discount rate is high the banks will borrow less and there will be less fluidity in the market. If the discount rate is low the banks will borrow more and increase the liquidity in the market. At high liquidity, the inflation will be high and the unemployment will be low. At low liquidity, inflation will be low and unemployment will be high.

b) Reserve requirement helps manage the excess funds in the banks and lending. At high reserve ratio banks will have fewer funds to lend and at low reserve ratio banks can lend more.

c) Federal fund rate is the rate at which the banks lend overnight to other banks or financial companies. Higher the rate lower the fund and vice versa. IF the rates are low the banks will borrow more from each other and if the federal fund rates are high banks can borrow more form each other.

d) Open market operation. The open market operation is buying and selling of bonds in the open market.

IN case of recession, the bank will buy bonds and increase the liquidity in the market increasing the demand.

In case of expansion, the banks will sell bonds and absorb the excess liquidity in the market. It will decrease the inflation and increase the interest rate.

Usefulness-

Limitations-