Explain two of the Fed's main tools of monetary policy and how each is used to...

Explain two of the Fed's main tools of monetary policy and how each is used to change the money supply if the Fed wants to do expansionary monetary policy.

Expert Solution

Answer : For expansionary monetary policy Fed use the following two main tools to change the money supply :

I) Fed purchase bonds and securities through the open market operation.

II) Fed reduce the required reserve.

If Fed purchase bonds and securities through the open market operation then the money supply increase in the economy. As a result, interest rate will decrease which will increase the consumption and investment. Due to increase in consumption and investment the aggregate demand increase which shift the AD curve to rightward. As a result, the economy reach at potential output level. Thus, Fed use open market operation tool to change the money supply for expansionary monetary policy.

If Fed reduce the required reserve then Commercial banks get more money to lend. As a result, the money supply increase in the economy which decrease the interest rate. Due to lower interest rate the consumption and investment increase. As a result, the aggregate demand increase which shift the AD curve to rightward and the economy reach at potential output level. Thus, Fed use required reserve tool to change the money supply for expansionary monetary policy.

Rahul Sunny answered 2 years ago

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