Management Notes

Management Notes

Reference Notes for Management
Monetary Policy Tools

Monetary Policy Tools – Federal Reserve System | Investment Analysis

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Monetary Policy Tools | Expansionary Monetary Policy | Contractionary Monetary Policy | Federal Reserve System | Investment Analysis | Management Notes

Federal Reserve System which is also called “The Fed” is the central bank of the United States (US) and is considered to the world’s most powerful financial institution. Fed was established after the US economy was repeatedly hit by financial panics and severe economic disruptions. Fed is the main regulator for the financial institutions of the country that holds the power to ensure the financial stability in the system (CHEN, 2020).

The major purpose behind founding Fed is to provide the country with a monetary and financial system that is safe, flexible, and stable. Some of the responsibilities of the Fed are as follows:

  • Managing Money supply and credit in the economy.
  • Regulation and Supervision of financial institutions for maintaining stability.
  • Through various depository institutions (banks, credit unions, etc.) it provides payment services to the public.

Federal Reserve uses monetary policy as a toolkit to control the money supply in the economy, to achieve sustained and high growth rates as well as to maintain low inflation rates. Depending on the assessments made by the policy-makers, the effectiveness of monetary policy can be analyzed. Monetary policies can either be Contractionary or Expansionary depending upon the money supply requirement in the economy.

Expansionary Monetary Policy by the Federal Reserve System

Expansionary Activities include expanding or increasing the supply of money in the economy. Fed implements expansionary activity by doing the below three things:

  • Government Securities purchase on the open market.
  • Lowering the discount rate.
  • Lowering the reserve ratio requirement.

 

 Expansionary Monetary Policy and impact on various economic variables

Economic Variables

Impact
Money Supply Increases
Credit Availability Increases
Security Prices Increases
Interest Rates Decreases

 

Expansionary activities decrease the interest rate which facilitates borrowing. When the interest rate is lower domestic bonds seem to be unattractive resulting increase in demands for foreign bonds and a decrease in demands for domestic bonds. When there a high demand for foreign bonds, the demand for the foreign currency rises, and the demand for domestic currency falls resulting decline in exchange rates (AMADEO, 2020). The decline in exchange rates causes an increase in exports, a decrease in imports ultimately increasing the balance of trade. When all things are kept constant, a decrease in interest rates leads to higher investment.

 

Contractionary Monetary Policy by Federal Reserve

Contractionary Activities include contracting or decreasing the supply of money in the economy. Fed implements Contractionary activity by doing the below three things:

  • Government Securities sell on the open market.
  • Raising the discount rate.
  • Raising the reserve ratio requirement.

 

Contractionary Monetary Policy and impact on various economic variables

Economic Variables

Impact
Money Supply Decreases
Credit Availability Decreases
Security Prices Decreases
Interest Rates Increases

 

Contractionary activities increase the interest rate which discourages borrowing. When the interest rate is higher domestic bonds seem to be attractive resulting decrease in demands for foreign bonds and an increase in demands for domestic bonds. When there a high demand for domestic bonds, the demand for the domestic currency rises and demand for foreign currency falls resulting higher exchange rate. Higher exchange rates cause a decrease in exports and an increase in imports ultimately decreasing the balance of trade. When all things are kept constant, an increase in interest rates reduces the capital investment.

As explained above about both of the monetary policy that has been conducted by the Fed, its usefulness depends upon the requirement of various economic scenarios in the country. We can’t just say this is better than that because each of the monetary policy tools has their role in different economic scenarios of the country to maintain stability in the money supply (D.Bordo, U.Choudhri, & J.Schwartz, 2002)

Therefore when there is a need for cash in the economy Fed implements Expansionary Activities to increase the money supply and when there seems to inflation prevailing Fed implements the Contractionary Activities to decreases the money supply in the economy.

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