What action could the Fed take to close a contractionary gap? 

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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The Fed is in charge of monetary policy in the United States.  In terms of monetary policy, there are three main actions that can be taken to close a contractionary gap.  First, bank reserve requirements could be reduced.  Second, interest rates could be lowered.  Finally, the Fed could buy government securities through open market operations. All of these actions would, in theory, help to close a contractionary gap.

In the United States today, only the last of these is a realistic step for the Fed to take.  Lowering reserve requirements is not likely to encourage banks to lend more if they are not confident that their loans will be repaid.  Lowering interest rates is not a serious possibility since interest rates are extremely low already.  There is simply no room to lower them in any important way.  That leaves buying government securities on the open market.  By doing this, the Fed pumps money into the economy.  By increasing the money supply, the Fed hopefully encourages economic activity.

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