The aim is actually to create a balance of money in circulation i-e bringing money supply and demand in equilibrium to accomplish business growth and economic stability. Secondly, Fed changes the Reserve ratio which means the percentage of commercial bank deposit liabilities required as reserves. And third is the change of discount rate which is the interest rate the Fed charges on loans to banks and thrifts. (McConnell and Brue, 2002)
Fed uses a “tight monetary policy” when an economy observes inflation (increasing trend in prices). Here I assume that it is a demand-pull inflation which means that Aggregate demand is excessive relative to the economy’s full employment level of real output. It is actually the spending that has resulted in inflation. Fed then reduces the money supply by open-market purchases, increase the reserves ration and the discount rates. Banks will in turn stop issuing new loans as old loans are paid back. Higher interest rate discourages investment, reduce aggregate demand and refrain this inflationary trend.
A typical business cycle has four stages which include peak, recession, trough and economic recovery. A “Peak” is observed when the economy reaches a temporary maximum point. Here, the economy is at full employment level and the output is at or very closer to economy’s capacity. Then, the peak is followed by an economic decline called as “Recession”. The total output produced, trade, prices, employment and income generated by an economy contracts and it observes a negative growth. The next stage is known as “Trough” where output and employment reaches a “temporary minimum”. The Fed in order to cope with this situation introduces an “easy monetary policy” which aims to increase money supply by pumping more money in the economy, lower reserves ration and discount rates. Investment is encouraged because of reduction in interest rates, aggregate demand increases and ...
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