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The Monetary Policy Tools

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Identify the four major tools of monetary policy. Then describe how changes in the Fed's major policy tools leads to: 1. Expansionary monetary policies
2. Restrictive or contradictory monetary policies.

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Solution Summary

This solution looks at the four major tools of monetary policy implemented by the Fed and gives an in-depth explanation of each one as well as situation examples. The tools are also discussed in relation to expansionary and restrictive/contradictory policies.

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Monetary policy tools:
1. Open market operation.
To increase money supply (expansionary monetary policy), the Fed will perform an open market purchase. In this case, the Fed will by US government Treasury securities from the open market. The Fed will pay the purchase with currency, therefore, the monetary base will increase by the amount of purchase.
ie. Money supply = monetary base (x) money multiplier.

You can also show the effect on this policy by using the graph of the money market based on the liquidity preference model. The graph shows the relationship between interest rate on vertical axis and quantity of money on a horizontal axis. The demand for money is negatively related to the interest rate, whereas, the money supply is fixed determined by the Fed (a vertical line at the amount of money supply). Through an open market purchase, the money supply will increase and the money supply curve will shift to the right by the amount of purchase.

An increase in money supply is expansionary, ie outputs are expected to increase mostly through the investment channel. That is a reduction in the interest rate will lead to the increase in investment and ...

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