Question

Can you explain how the Federal Reserve utilizes each of the four monetary policy tools to implement an expansionary monetary policy and contractionary monetary policy?

Answer 1

The four monetary tools used by Fed to control the level of money supply in the economy are as follows:

a. Discount Rate - It is the interest rate which Fed charges from commercial banks for short term loans. The Fed reduces discount rate when implementing expansionary monetary policy and increases discount rate when it is implementing contractionary monetary policy.

b. Reserve Requirements: It refers to the portion of Net time and demand deposits which a commercial bank has to keep with Fed or hold as cash in its vault. When implementing expansionary monetary policy, the reserve requirements of the banks are decreased and in case of contractionary monetary policy, the reserve requirements of the banks are increased.

c. Open Market Operations: It refers to buying and selling of government securities in the open market to influence the level of money supply in the economy. In order to increase the level of money supply, Fed purchases government securities in the open market and in order to reduce the level of money supply, fed sells government purchases in the open market.

d. Interest on reserves - The interest paid on excess reserves held at the Central Bank. When Fed wants to implement expansionary monetary policy, then it reduces interest paid on excess reserves. And when Fed has to implement contractionary monetary policy, it increases interest paid on excess reserves.