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Monetary policy involves control of the quantity of money in the economy. The Federal Reserve is responsible for monetary policy in the United States.
Open market operations is the buying and selling of government bonds by the Federal Reserve. When the Federal Reserve buys a government bond from a bank, that bank acquires money which it can lend out. The money supply will increase. An open market purchase puts money into the economy.
When the Federal Reserve makes a loan to a member bank, the loan is called a discount loan. The interest rate on a discount loan is called the discount rate.
Lowering the discount rate encourages banks to take out more discount loans while raising the rate discourages banks from borrowing from the Fed. Therefore, lowering the discount rate puts money into the economy; raising the discount rate takes money out of the economy.
The reserve ratio is the percentage of deposits banks are required to hold as vault cash and not loan out.. Lowering the reserve ratio allows banks to loan out a greater fraction of deposits and the money supply would increase. Raising the reserve ratio would cause the money supply to shrink.
To increase the money supply, the Federal Reserve can
Expansionary monetary policy is appropriate when the economy is in a recession and unemployment is a problem.
Changes in the money supply affect the economy through a 3 step process.
To decrease the money supply, the Federal Reserve can
Contractionary monetary policy is appropriate when inflation is a problem.
|David A. Latzko
Business and Economics Division
Pennsylvania State University, York Campus
office: 13 Main Classroom Building
phone: (717) 771-4115
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