Describe how changes in the Fed’s major policy tool leads to expansionary and restrictive monetary policies.

Question

What will be an ideal response?

Answer 1

With an expansionary monetary policy, the Fed wants to expand the money supply to promote spending, borrowing and growth. To do this, the Fed will first lower the target for the Federal funds rate and engage in open market operations of buying bonds to reach this target. These purchases will increase the level of reserves in the banking system and expand the money supply.
With a restrictive monetary policy, the Fed wants to contract the money supply to rein in inflation. To do this, the Fed would first raise the Federal funds rate target and engage in open market operations of selling bonds to reach it. These sales take reserves out of the banking system and shrink the money supply.