Question

1. what happens when the FED restricts monetary policy?

2. what are the effects of the Fed reducing the interest rate?

3. what are your thoughts about the tools the FED uses? Are you in agreement or disagreement with any of their tools? If so, which ones and why?  

Answer 1

a.> FED generally restricts monetary policy to slow economic growth. This is called restrictive because banks are limiting liquidity. It decreases the amount of capital & credit banks are willing to lend. In making loans, credit cards and mortgages more costly hence reducing the money supply. That limits competition, thus reducing economic growth and inflation. It can also be called as contractionary monetary policy.

Restrictive monetary policy aims at warding off inflation. A significant amount of inflation is in good health. An annual price rise of 2 percent is generally beneficial for the economy because it increases demand. People expect a higher price later so they buy more now.

b.> The Fed is lowering interest rates to boost economic growth. Lower cost of funding will promote borrowing and investment. Nevertheless, they may spur unsustainable growth and likely inflation when the rates are too low. Inflation eats away at purchasing power and may threaten the sustainability of the desired expansion of the economy. It is easy to think of it as preventing savings when the Fed is lowering rates. It lowers the price of money. It encourages borrowing, and discourages savings. It basically pulls money from bank accounts and into the economy.

c.>

The Fed can use four tools to achieve its monetary policy goals: the discount rate, reserve requirements, open market operations, and interest on reserves.

1. The discount rate is the interest rate on short-term loans that Reserve Banks offer to commercial banks. Federal Reserve discount-rate lending complements open market operations in reaching the federal fund's target rate and acts as a source of liquidity for commercial banks to back up. Lowering the discount rate is broad since certain interest rates are affected by the discount rate. Higher rates promote business and enterprise lending and spending. Similarly, increasing the discount rate is contractionary, since certain interest rates are affected by the discount rate. Higher rates deter business and company lending and spending.

2. Reserve requirements are the portions of reserves that banks are expected to keep in currency, either in their vaults or on a reserve bank deposit. A reduction in reserve requirements is expansionary as it raises the funds available for lending to customers and companies within the banking system. A rise in reserve requirements is contractionary, as it decreases the funds available for lending to customers and companies in the banking system. The Governing Board has exclusive control over amendments to the criteria for reserves. The Fed's criteria for reserves rarely change.

3. Open Market Operations: U.S. government securities purchasing and sale has become a successful tool. As we heard earlier, this device is regulated by the FOMC and run by New York's Federal Reserve Bank.

4. Reserve interest is the newest and most commonly used tool provided by Congress to the Fed after the 2007-2009 financial crisis. Reserve interest is paid out on surplus funds held at Reserve Banks. Remember that Banks are mandated by the Fed to keep a percentage of their reserve deposits. Besides these stocks, banks also keep additional funds on hand. The new policy of charging interest on deposits enables the Fed to use the interest to manipulate bank lending as a monetary policy weapon.