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Tools of Monetary Policy

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How can the 3 major tools of monetary policy correct a recessionary gap and an inflationary gap?

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Solution Summary

The solution first list of the the three tools under the control of Fed. These tools are part of the US monetary policy. The solution then explains how the fed can use these tools to correct a recessionary gap or an inflationary gap. The solution is detailed and yet very clear. It is an excellent starting point for students wishing to learn more about the Fed and the tools that it has at its disposal. Overall, an excellent response.

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The 3 major tools of monetary policy are:
1. Open market operations: purchases and sales of National Treasury and federal agency securities. It is the primary tool of monetary policy.
2. The discount rate: the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility. When it goes up (or down) it discourages (or encourages) borrowing.
3. Reserve requirements: the amount of funds that a depository institution must hold in reserve against specified deposit liabilities within limits specified by law.

Let's define the two kinds of output gaps:
1. RECESSIONARY GAP: The difference between the equilibrium real production achieved in the short-run aggregate market and full-employment real production. This occurs when short-run equilibrium real production is LESS ...

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