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stabilization policy and Fed

> Respond to the following questions:
> If the Federal Reserve were to engage in an activist stabilization
> policy, in which direction should they move the money supply in
> response to the following:
> A wave of optimism boosts business investment and household
> consumption.
> To balance the budget, the federal government raises taxes and
> reduces expenditures.
> OPEC raises the price of crude oil.
> Foreigners experience a reduction in their taste for US produced
> Ford automobiles
> The stock market falls.
> If the Federal Reserve were to engage in an activist stabilization
> policy, in which direction should they move interest rates in response
> to the same events listed in Question 1? Explain.
> Explain the relationship between FED policy in terms of monetary supply
> and policy in terms of the interest rate.

Solution Preview

The Federal Reserve controls the three tools of monetary policy--open market operations, the discount rate, and reserve requirements. The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. The Federal Reserve Act of 1913 gave the Federal Reserve responsibility for setting monetary policy.
The Board of Governors of the Federal Reserve System is responsible for the discount rate and reserve requirements, and the Federal Open Market Committee is responsible for open market operations. Using the three tools the Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and in this way alters the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.

The central bank influences interest rates by expanding or contracting base money, which consists of currency in circulation and banks' reserves on deposit at the central bank. The primary ways that the central bank can affect base money is by open market operations or sales and purchases of second hand government debt, or by changing the reserve requirements. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the ...

Solution Summary

The three tools of monetary policy are summarized.