Assuming that the Fed judges inflation to be the most significant problem in the
ID: 1190196 • Letter: A
Question
Assuming that the Fed judges inflation to be the most significant problem in the economy and that it wishes to employ all of its policy instruments except interest on reserves, explain how the Fed should implement its three policy tools to contain inflation.
In your essay, focus on the following questions:
What are the different policy tools the Fed uses to address significant economic problems?
What problems can inflation cause in an economy?
Which policy tool or combination of policy tools would work best to contain inflation?
Does the policy tool or combination of policy tools differ in case of low inflation?
Explanation / Answer
Fed uses different monetary policy tools to combat inflation. The following are three important tools used to control inflation rate in the economy;
Open market window operations: Fed sells government securities to lower the money flow in the economy buy locking people's money in securities. With lower money flow, there is lower inflation.
Discount rate: This is the rate at which the bank borrows loan from Fed. If this is increased, then loans become more expensive for bank and money circulation in the eocnomy slows down. This reduces the inflation rate.
Required reserve ratio: This is the maount of reserves that commercial banks need to hold as reserves. Fed increases the required reserve ratio when there is a need for contractionary monetary policy.
Federal open market committe: Fed manipulates the selling and buying of bond to target the market rate at which banks lend loan to each other. The greater the market rate, the lower is teh money circulation and hence lower is the inflation. This is similar to open market operation.
Inflation creates problems in the way of economic growth and development. Inflation reduces the purchasing power, lowers the incentive of spending, which in turn reduces the consumption and expenditure level . The most effective policy would federal open market committe since it combines the Fed intiatives to reach the market interest rate level quickly.