Question

Describe the channels by which monetary policy ripples through the economy and explain how each channel operates.

Suppose the Fed raises the federal funds rate.

When the Fed raises the federal funds rate, it makes an open market _____

Answer 1

Monetary policy operates through various channels such as open market operations, the credit channel, and the exchange rate channel. Open market operations involve buying or selling U.S. Treasury bonds to affect bank reserves and interest rates. The credit channel impacts borrowing costs for consumers and businesses, while the exchange rate channel affects the value of the currency and trade balance.

Step-by-step explanation:

Monetary policy operates through various channels to impact the economy. One of the main channels is through open market operations. In this process, the central bank buys or sells U.S. Treasury bonds, which affects the supply of bank reserves and interest rates. By increasing or decreasing the supply of reserves, the central bank can influence the federal funds rate, a short-term interest rate that reflects credit conditions in financial markets.

Another channel through which monetary policy operates is the credit channel. Changes in interest rates can impact borrowing costs for consumers and businesses. When the central bank raises interest rates, it becomes more expensive to borrow money, which can reduce spending and economic activity.

The exchange rate channel is another important channel of monetary policy. When the central bank raises interest rates, it can attract foreign investors looking for higher returns on their investments. This leads to an increase in the value of the domestic currency relative to other currencies, which can make exports more expensive and imports cheaper, affecting the balance of trade.