Monetary Policy, Expansionary vs Contractionary policy by the Federal Bank

Summary

• How does Federal Reserve make use of Reserve Requirements?
• How the Federal Reserve fights recession using expansionary monetary policy
• How the Fed / Central bank contracts and expands an economy
• Contractionary Monetary Policy occurs when the Federal Reserve buys Government Bonds and Treasury Bills
• Who issues directive on how to buy and sell government bonds to/from banks
• What happens if the Fed believes the economy is experiencing (or about to experience) high levels of inflation

Introduction

Monetary policy refers to the actions undertaken by the nation’s central bank to control the money supply to achieve macroeconomic goals and sustainable economic growth. Monetary policy can either be expansionary or contractionary.

Expansionary monetary policy involves an increase in money supply which in turn increases aggregate demand. Expansionary policy is used when the economy is under recession and unemployment rates are high.

Contractionary monetary policy involves the decrease in money supply to decrease consumer spending and aggregate demand, which contracts the economy.

The Federal Open Market Committee (FOMC) within the federal reserve system, is charged with the duty of overseeing the nation’s open market operations, making important decisions regarding federal funds rate, and regulating the money supply. FOMC meets every six months, regulating Central bank’s decisions and approving policies.

The three main monetary policy tools

• Open Market Operations
• Federal Funds Rate
• Reserve Requirements

Open Market Operations

Expansionary

The Central bank purchases government securities and bonds from commercial banks which increase the amount of money available in cash vaults. Increased reserves raise the availability of loans. As people borrow more, the money supply in the economy increases which stimulates capital investment and an increase in aggregate demand. The result is more employment opportunities and higher output that causes economic expansion

Contractionary

The central bank sells government securities to commercial banks, decreasing cash reserves. This decreases the amount of money available as loans to borrowers causing upward pressure on interest rates and a decrease in the money supply. Less money supply decreases capital investment and aggregate demand, which contracts the economy

Reserve requirements

Expansionary

Reserve requirements refer to the amount of money that the central bank requires commercial banks to hold as cash in their vaults and not lend out as loans.

When the reserve requirement ratio is decreased, the banks hold less amount of money and have more to offer as loans. As loans increase, the money supply in the economy increases which in turn increases economic growth/Expansion

Contractionary

When the reserve requirement ratio is increased, banks are required to hold more cash in vaults than what is available to offer as loans to borrowers. This decreases the money supply and aggregate demand, contracting the economy

Federal Funds Rate

The federal funds rate is the rate at which banks can borrow overnight loans from other banks, whenever there is increased demand for withdrawals and loans. High federal funds rate increases interest rates and low funds rate decreases interest rates.

Expansionary

The central bank lowers the federal funds rate, which makes it cheaper for commercial banks to get overnight loans, and hence lowers interest rates for loans. This increase demand for loans, increasing the money supply in the economy, raising aggregate demand and economic growth

Contractionary

Central bank raises the federal funds rate, which increases interest rates on loans. This decreases the demand for loans and money supply. This causes decline in aggregate demand and investment causing economic contraction.