Discussion on Federal Reserve and Inflation

Discussion on Federal Reserve and Inflation

Topic 1

What policy instruments does the Fed use for the monetary policy?

The Federal Reserve uses the following monetary policy instruments to influence the money supply in the economy; Open market operation, reserve requirement and discount rate (Arnold, 2010). The Fed influences the money supply by buying or selling U.S. government securities in the financial market using the open market operations. Second, discount rate refers to the interest rates that are charged by Fed on banks that borrow short-term loans. Third, reserve requirement entails the amount of money that the financial institutions are required to keep with the Federal Reserve Banks.

What are the pros and cons of using expansionary and contractionary monetary policy tools under the following scenarios: depression, recession, inflation, and robust economic growth? Which do you think is more appropriate today?

During depression: it is the period when the economy experiences a long-term downturn in economic activities that include deflation, high unemployment rates and reduction in real GDP. The expansionary monetary policy will increase the money supply thus stimulating business investment. This will also increase consumer demand, the creation of jobs and renewed economic growth. Therefore, expansionary monetary policy is the appropriate policy to use. The disadvantage of using expansionary monetary policy is the idea of the liquidity trap. At the point of the liquidity trap, the expansionary monetary policy will be ineffective since the interest rate cannot be reduced beyond that point.

The application of contractionary monetary policy is inappropriate during depression hence it is harmful to the economy.

During recession: refers to the period when the economy experiences a general decline. The monetary policy that should be used is expansionary since it will stimulate consumer demand and create jobs by reducing the cost of money hence lowering unemployment rate. In the case of recession with stagflation, the contractionary monetary policy will be helpful to reduce inflation rate by lowering the prices of goods and services.

During inflation: refers to the situation when the economy experiences a persistent increase in prices of goods and services. Contractionary monetary policy is useful since it will reduce the money supply thus lowering inflation. Expansionary monetary policy can be harmful since it will influence continued price increase hence propelling high rate of inflation.

During robust economic growth: it is a period when the economy experiences expanding GDP. In case the aggregate demand exceeds aggregate supply, the result will be demand pull inflation. Contractionary monetary policy in this situation will result in consumers relocating their income to paying debts such as personal loans and mortgage. This will reduce aggregate demand. The disadvantage of this policy is the increase in unemployment and reduction in GDP growth. The expansionary monetary policy will encourage capital investment hence ensuring that the aggregate supply keep pace with aggregate demand. The con of this policy is that the aggregate demand will always outstrip the aggregate supply causing inflation.

Today the U.S. is experiencing robust economic growth; therefore, it will be appropriate to use expansionary monetary policy to achieve sustainable GDP growth by encouraging capital investment.

Topic 2

What is the inflation tax, and how might it explain the creation of inflation by a central bank? Explain how inflation affects savings and investment.

Inflation tax refers to cash or anything that has a fixed dollar value gradually loses its value over a period. When the prices of goods and services rise in the economy, the value of money reduces (Arnold, 2010). Therefore, when the government prints more money to raise revenue, it uses resources from households by taxing individuals’ money holdings through inflation instead of providing them with a tax bill. The government can use inflation tax to raise revenue in a situation when they are unwilling to generate revenue by raising taxes.

Inflation will impact savings by eroding the purchasing power hence a person will have to pay more for the same goods a year later. Inflation discourages investment because it makes the nominal value uncertain hence investors find it difficult to make decisions.

Inflation distorts relative prices. What does this mean and why does it impose a cost on the society?

Relative prices explain the relative scarcity of goods in the economy so that they may be allocated efficiently. Some prices of goods rarely change; therefore, in case inflation rises, the relative prices of goods will vary greatly. Inflation will lead to changes in the relative prices, and since it did not signal changes in the scarcity of goods, it will result in an inefficient allocation of resources.



Arnold, R. A. (2010). Macroeconomics. Mason, OH: Cengage Learning, South Western.

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