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3 Key instruments used by Fed to conduct a monetary policy:
1. Open market operations
2. Reserve requirements changes
3. Discount rate changes
The Fed raises the banking sectors’ reserves through buying government bonds – money supply increases through expansion.
Arguments in favour of Expansionary Monetary Policy
In the short run: expansionary monetary policy has a positive effect on output, demand and employment. Over the short term the interest rates will fall, that in turn will encourage investment and consumption spending. Output and employment will be stimulated by this increase in demand that occurs.
The expansionary monetary policy can be used in a depression and recession to stimulate the economy.
Advantage: The Feds can buy government bonds from banks and corporations to increase the money supply. More currency is put into the supply of money through buying bonds with currency held in the reserve.
Effect of expansionary monetary policy over the long-term: Rise in inflation.
Arguments against Expansionary Monetary Policy
Loosening the monetary policy will cause the bond prices to increase and interest rates to decrease. Demand for local bonds will fall and a demand for foreign bonds will rise, due to the lower interest rates. That will cause a fall in domestic currency and an increase in demand for foreign currency and in turn it will lead to a decline in the exchange rate.
Effect of expansionary monetary policy over the long-term: Rise in inflation. The expansionary monetary policy will then fail to stimulate actual output and employment opportunities, as there will be an uncertainty due to higher inflation rates generated, also slowing economic activity down.
When the Fed follows a tight (restrictive) monetary policy, through lowering the money supply, nominal interest rates will increase and investment and consumption will decrease. By decreasing the money supply, liquidity is restricted and lowers the economic growth. Tightening the monetary policy will also stop inflation.
In the US the monetary policy of the Fed can be too expansionary. This can be due to the total output gap (difference between the actual GDP and potential output) than can be smaller than what policy institutions in the US indicate.
The US expansionary monetary policy leads to depreciating the value of currencies in developed countries that causes damaging economic growth in emerging and developing countries.
by I. Roodt (boomerangs621)