Monetary Policy to Sustain Economic Growth - Essay Example

Open-market sale operations are conducted to reduce the circulation of money in the market through the sale of securities, bonds, etc to governments, the general public, etc. 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)

The term Business cycle refers to alternating rises and declines in the level of business activity. Both unemployment and inflation are associated with business cycles.
Fed uses a “tight monetary policy” when an economy observes inflation (an 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 the spending that has resulted in inflation. Fed then reduces the money supply by open-market purchases and increases the reserves ratio 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 from 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 the economy’s capacity. Then, the peak is followed by an economic decline called a “Recession”. The total output produced, trade, prices, employment, and income generated by an economic contract, and it observes negative growth. The next stage is known as “Trough” where output and employment reach a “temporary minimum”.

The Fed to cope with this situation introduces an “easy monetary policy” which aims to increase the money supply by pumping more money into the economy, lowering the reserves ratio, and discount rates. Investment is encouraged because of a reduction in interest rates, aggregate demand increases and the economy recovers. The final stage of the business cycle is “recovery” in which output and employment rise towards full employment. It must be highlighted that an economy will not have a single permanent peak and stability point or a permanent trough rather it observes declines due to various external factors and later economic recoveries because of changes in monetary policy. Read More