Answer one of the following options (Option A or Option B):
Option A: After reading Chapter 13 in the textbook and the lecture notes posted in Module #6, describe two of the three monetary policy tools that the Federal Reserve could use to help improve the economy if the economy is currently in an inflationary gap.
Option B: After reading Chapter 15 in the textbook and the lecture notes posted in Module #6, describe the Keynesian transmission mechanism for a decrease in the money supply, assuming that no liquidity trap exists and that investment is not interest insensitive. What impact would this money supply decrease most likely have on Real GDP and the price level under these circumstances?
Monetary Policy Tools: Changing the Required Reserve RatioThe Fed has three primary monetary policy tools. I have listed them in order from the tool that is used the least often to the tool that they use most frequently:Changing the required-reserve ratio (r)The Fed will lower r to close a recessionary gap and raise r to close an inflationary gap. Lowering r allows banks to loan a greater portion of each deposit, which leads to more loans and more spending (stimulating the economy). Raising r will have the opposite effect. As I previously mentioned, it has been nearly 30 years (4/92) since the Fed last changed r and it took them almost ten years to change it the time before that. This is not a tool that the Fed takes lightly — the do not use it unless they feel that it is absolutely necessary.
Monetary Policy Tools: Changing the Discount RateThe discount rate is the interest rate that the Fed charges to banks that need to borrow reserves from the Fed (recall that the Fed serves as the lender of last resort for banks). The Fed will lower the discount rate to close a recessionary gap and raise the discount rate to close an inflationary gap.Lowering the discount rate allows banks to lower the interest rate that they charge to their customers, which encourages borrowers to take out more loans and to spend more (stimulating the economy). The opposite will happen if the Fed raises the discount rate.The Fed is also indirectly responsible for setting the federal funds rate (the rate that banks charge other banks that need to borrow reserves). Caution: This terminology is somewhat tricky. Make sure that you understand the difference between the federal funds rate and the discount rate.The members of the Fed board will often use the meetings of the FOMC as an opportunity to change the discount rate (although they do not have to wait for these meetings to do so). When an FOMC meeting nears you will hear a great deal of speculation in the financial news over the anticipation of the Feds actions.
Monetary Policy Tools: Open Market OperationsThe term open market operations refers to the Fed buying and selling US government securities (the same securities that we discussed in the public debt section of Chapter 11).The Fed will buy government securities to close a recessionary gap and they will sell government securities to close an inflationary gap.When the Fed buys government securities from a bank, the Fed pays the bank for the securities by depositing money into the banks reserve account. The bank can then use these new reserves to make new loans (which stimulates the economy). The analysis is not much different when the Fed buys the securities from a non-bank. In this case, the Fed will pay the securities-holder with a check and the securities-holder will then deposit the check into his account, creating new reserves. When the Fed sells government securities, the process works in reverse and helps to slow down the economy.Open market operations are conducted through the New York District Bank and are performed frequently to fine-tune the money supply.To summarize the Fed’s monetary policy tools:Closing a recessionary gap requires an increase in the money supply. The Fed can achieve this by lowering the required reserve ratio, lowering the discount rate and/or buying government securities on the open market.Closing an inflationary gap requires a decrease in the money supply. The Fed can achieve this by raising the required reserve ratio, raising the discount rate and/or selling government securities on the open market.
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