Economics P3 Assignment - Essay Example

Short-Term Interest Rates In most cases, the Federal Reserve use either contractionary or expansionary money policy to influence the short-term interest rates of fund. In a contractionary period, there is a higher level of short-term interest rate as shown in the figure below this means that the banks will avoid borrowing money from the Federal Reserve banks as they keep their reserves at the authorized level. As a result, the banking institutions will change a higher rate as it lends less money out, because they are borrowing money at a higher rate thus, loans become expensive, and the economy slows down.

In addition, the Federal Open Market Committee (FOMC) issue trading on the open market operations as it promises higher returns on interest rates reduces the quantity of money supply (Board of Governors of the Federal Reserve System, 2012). When the Fed uses the expansionary monetary policy, the interest rates fall leading to cheaper interests rates and banks consequently borrow more funds from the Federal Reserve banks to maintain their reserve requirement rate. At this point, the open market operations that were bought earlier from the Federal Open Market Committee (FOMC) are sold at a higher interest rate leading to increase in money supply in the economy.

(Mankiw, 2012) Foreign Exchange Rates Just like, local exchange rates that are affected by the monetary policy tools, the foreign exchange rates are also affected. As a result, conventional monetary policy that are implemented by the Federal reserve has a greater influence on the exchange rate as foreign exchange interventions take place to control the economy's demand and supply of money (Board of Governors of the Federal Reserve System, 2012). As a result, contractionary monetary policy implementation by the Federal Reserve creates shocks in the economy, as it allows the foreign exchange rate to appreciate for a shorter period and thereafter, the exchange rate depreciates with time to its original level.

Long-Term Interest Rates More than often, the Federal Reserve decision to use the tools of monetary policy affects long-term interest rates in the economy. Depending on Fed uses, contractionary and expansionary monetary policies the effects will be realized in the long-term interest rate (Board of Governors of the Federal Reserve System, 2012). With an increase in the discount rate, reserve requirement and open market operations, the long-term interest rates will increase over time. This is because, banking institutions will have less funds as compared their reserve requirement to lend out to its customers with the ever-increasing long-term interest rate.

However, expansionary monetary rate increases the money supply as the interest rate reduces and increased credit is widely available leading to lower long-term interest rate. As a result, the demand for money increases leading to more investments. The Amount of Money and Credit in the System In most instances, the Federal Reserve uses the tools of monetary policy to influence the availability and cost of money and credit in its economy. As a way of tightening money supply and credit availability, the Federal Open Market Committee FOMC directs the New York stock exchange to sell government securities (Mankiw, 2012).

As a result, it collects funds from the public and collect payments through the banks by reducing their reserve account in the main Federal Reserve Bank. In the end, banks have less money to lend to its customer