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1. List and explain the 3 tools of Federal Reserve Monetary Policy. 2. Explain how the Federal Reserve would use expansionary monetary policy to close a recessionary gap. Explain how the money supply, interest rate, investment spending, consumer spending, aggregate demand, real GDP, unemployment, and price level is affected. Illustrate this graphically below

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Monetary policy by the central monetary authority (Federal Reserve in the US) is conducted to influence, target or stimulating the aggregate spending through the channel of credit creation and liquidity. The tools are quantitative easing, open market operations, reserve requirements and discount rate. All of them are aimed at either targeting interest rate, or inflation rate a) The discount rate The discount rate is the interest rate the Fed charges on loans that it makes to banks. If the Fed wants to lower the money supply, it increases the discount rate. Higher the discount rate, less encouragement will the banks get to borrow from the Fed. When the borrowing is reduced, the Fed, the amount of loan granted is reduced in tandem and so the money supply reduced. This shifts AD to the left, reducing it, causing output to decline and interest rate to increase b) Reserve requirements Higher reserve requirements would reduce the bank profits as it limit the amount of loans they can grant. It is just like a tax. The lending capacity will be reduced and so the money supply will fall. This shifts AD to the left, reducing it, causing output to decline and interest rate to increase c) Open market operations Open market operations is the process of the buying and selling of government securities by the Fed in the open market. When the Fed has an aim to reduce the money supply, it enters the money market and sells government securities. Currency in circulation, deposits all are reduced and through the multiplier effect, money supply is reduced. This shifts AD to the left, reducing it, causing output to decline and interest rate to increase d) Quantitaive easing Here the Fed buys predetermined amount of government securities in the economy and is mostly used when inflation is negative or so low and also when interest rate reaches a zero lower bound and conventional tools are unable to increase aggregate demand. This shifts AD to the right, increasing it, causing output to rise. This may not change rate of interest.

When there is a recessionary gap, real GDP is less than potential GDP. In that scenario, monetary expansion can bring the ecoPrice level LRAS SRAS Pl P* AD Recession ary AD Real GDP

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