Explain Why The Required Reserve Ratio Is Rarely Used To Conduct Expansionary Monetary Policy.

6.2.4

1. The two tasks with which the Fed is charged are promoting the health of the banking industry and promoting the overall health of the economy. Various regulations allow the Fed to achieve the first of these tasks. Three tools allow it to achieve the second.

A. List and briefly describe the three policy tools the Fed can use to promote the overall health of the economy. (3 points)

Three tools are respectively required reserve ratio, discount rate, and open market operations.
The required reserve ratio is the minimum percentage of deposits banks need to deposit in the central bank. The discount rate is the interest rate that the Fed charges banks for overnight loans.
Open Market operations are the buying and selling of

With this purpose, the Fed will decrease required reserve ratio, decrease discount rate, or buy bonds. Contractionary monetary policy is quite the opposite, where the Fed would increase required reserve ratio, increase discount rate or sell bonds.

C. Explain why the required reserve ratio is rarely used to conduct expansionary monetary policy. Specifically state how it would be used, and why that's usually not a great idea. (4 points)

The required reserve ratio method is rarely used because the ratio of required reserves is fundamental to the stability of the banking systems, which cannot be frequently adjusted. The expansionary policy requires reserve ratio to decrease, but on the other hand this would also increase the money multiplier. It’s usually not a good idea because banks would have fewer reserves in times of recession when borrowers are more likely to default in recession time.

2. The most important tool the Fed uses to conduct monetary policy is open market operations (OMOs), a tool controlled by the Federal Open Market Committee (FOMC).

A. Explain what OMOs are. (2 points)

OMOs are the policy which the Fed uses the amount of bonds to influence the money

The money market (3 points)

When the money demand curve is flatter, then monetary policy will fail to affect RGDP. This means that people are sensitive to changes in interest rates.

II. Investment demand (3 points)

When firms are not sensitive to interest rates when making investment decisions, monetary policy is not that effective. This is when the investment demand curve is steeper.

III. Aggregate supply (3 points)

In the long run, the economy doesn’t stay above full employment, so production costs increase, the AS curve shifts to the left, RGDP/output decreases, and the price level increases more.

If the Fed employs an expansionary monetary policy when there is a supply shock, then
RGDP will not be affected. Or if it uses a contractionary monetary policy to combat inflation, then the RGDP will also not be affected.

5. The equation of exchange is an identity that relates the money supply, velocity, the

price level, and real output. An identity is something that is true by definition.

A. One group of economists, the monetarists, look at the equation of exchange and say that the Fed should simply increase the money supply by an annual rate equal to the long-run growth rate of the economy. Explain the effect that such a policy