Question

please answer this in a compelte, wel explained essay format. please answer both for thumbs up

3) Traditionally, the Fed has had three major tools it can use to adjust the money supply. List and explain how each tool works. Which is the Fed's favorite and why? 4) Why do we say that when a bank makes a loan it is creating money? Explain fully.

Answer 1

As per policy we have to answer first question

Answer-1)

In United States, Fed is the central bank. Congress created Fed to provide the country with a purpose of providing a flexible, safer, consistent and stable financial and monetary system. The important tasks of Fed included issuance of currency; lending to financial institutions & performing the role of an emergency lender; banks supervision; setting and holding requirements for the reserve; acting as a fiscal agent; control of money supply; and providing for check collection.

Monetary policies are the actions taken by Fed for controlling the monetary as well as financial status with the target of attaining low rate of inflation and sustainable economic growth in the country. Expansionary monetary policy is applied by FED when it wants an expansion (increase) the supply of money for stimulating the economic activities. An expansionary policy targets to stimulate investment and consumption spending, and also decreases the rates of interest thus causing the aggregate demand curve to shift right. Contractionary monetary policy would be applied by FED when it targets to contracts (decrease) the supply of currency of the nation. It reduces the supply of money, increases rates of interest and decreased the aggregate demand

The tools that are used by the central bank under monetary policies include the reserve requirements, discount rate, and the open market operations:

--Reserve requirements refers to the portions of deposits that banks are required to hold in cash, either in their vaults or on deposit at a Reserve Bank. A fall in reserve requirements is expansionary as in the banking system it raises the funds available to lend to consumers and businesses. A hike in reserve requirements is contractionary because it causes a decline im the funds available in the banking system to lend to consumers and businesses.

-- Discount rate refers to the rate of interest that the Reserve Banks charge commercial banks for short-term loans. Lowering the discount rate will be expansionary as it has influence on other rates of interest. The lower rates will encourage spending and lending by businesses and consumers. In a similar approach, an increase in the discount rate will be contractionary because the rate of discount has influence on the other interest rates. The higher rates will discourage spending and lending by businesses and consumers.

--Open market operations (OMO) is involved in the buying and selling of government securities in the open market with a goal of the expansion or contraction of the amount of money in the banking system, facilitated by the Federal Reserve (Fed). In the US the Federal Reserve when a central bank is interested in giving stimulus to the economy by increasing the money supply then, it purchases government bonds from commercial banks and the public. On contrary, when the central bank is interested in controlling inflation, it sells government bonds to the public and commercial banks.

-- Interest on reserves: When FOMC want to create a higher incentive for banks to lend their excess reserves, it can reduce the rate of interest it pays on excess reserves. Consequently the banks tend to lend money instead to hold it in reserve thus resulting to an expansionary policy. In a similar approach, if FOMC want to reduce the bank's incentive to hold more excess reserves, it reduce the lending by increasing the interest rate paid on reserves, and leading to a contractionary policy

Among all the tools of monetary policy, the Fed uses OMO the most because of it's easiness and flexibility.