Question

Through the use of one monetary policy tool describe how the monetary multiplier functions in the economy of the United States.

Answer 1

The monetary policy adopted by Federal Reserve has 4 main tools:

1. Discount Rate

2. Interest on Reserves

3. Open Market Operations

4. Reserve Requirement

Money Multiplier or Monetary Multiplier function is basically Capital Infusion. It means the disproportionate increase of income due to increase in spending initiated by one of the Monetary Policy tools.

To understand this function more clearly we will use the tool: Interest Rates

If the Fed decides to increase the spending in the economy , it will reduce the interest rates and that will encourage borrowing and discourage savings. The fall in interest rate will lower the earnings on savings and that will lead to decrease in motivation to save. This will promote consumption and expenditure which in turn will increase economic activity in the market and increase output. As the output increases this will increase employment and income levels in the economy, which can also be understood as Monetary Multiplier Effect.