Assignment Example | Topics and Well Written Essays - 1000 words - 69

Assignment Example Fed can purchase government either securities or lowers current reserve rations. In doing so, interest rates will fall and hence bringing the economy back to full employment. Suppose on observing that there is excess money supply in the economy, Fed will use open market operations to try to reduce the excess supply. Sales of government securities contract the assets accessible to lend and tend to increase the federal funds rate. Policymakers call this contractionary monetary policy or tightening. The Fed is targeting an interest rate level that would enable it achieves and controls its goal for employment. Economic growth, interest rate stability, and inflation can hit this rate target by choosing an appropriate value of money supply that will equate to money for equilibrium conditions in the capital market. The sale of government securities leads to a decrease in money supply from MS1 to MS2 in the economy. As a result, the current reserve ratio increase and hence putting an upward pressure on the Fed interest rate (Setterfield 105-116). Therefore, contracting policy results in the increase in interest rates from R1 to R2 and hence the cost of borrowing from commercial banks increases discouraging borrowing. When Fed sells government securities, it reduces money supply in the economy. The fall in money supply results in an increase in interest rates to R2. The increase in the interest rates reduces the level of aggregate demand and investment to I2 and hence a reduction in real GDP. As soon as the economy is in the recessionary gap, the Fed will implement an expansionary monetary policy to upsurge money supply in the market through three monetary policy instruments. By buying government securities and bonds, the Fed target will be to reduce the interest rate level. Moreover, it can lower the reserve rate or lessen the discount rate. The move will lead to a reduction in lending rates; hence, commercial banks will be encouraged borrowing