Monetary Policy

According to the simulation, there are three key economic tools used by the Federal Reserve to control the monetary policy.

1. Spread between the Discount Rate and the Federal Funds Rate

2. Required Reserve Ratio

3. Open Market Operations

These economic tools influence the money supply in the following ways:

1. Difference in Discount Rate and Federal Funds Rate:

Banks are able to borrow from the Fed if the discount rate charged by the Fed is lower than the federal funds rate charged by other banks. As the discount rate is decreased, banks shift their source of borrowing from other banks to the Fed. As they do so, the total amount of money in the system is increased. If the spread is positive, banks will always borrow from other banks, this will have no effect on the money supply.

2. Required Reserve Ratio:

The percentage of deposits any bank holds as reserves. The Fed mandates the ratio. When the ratio is decreased, banks are required to hold a lower percentage than reserves and can lend more to their customers, in-turn increasing money supply in the economy. The opposite can occur, causing banks to drain the system due to the decreased money supply.

3. Open Market Operations:

Items such as T-Bills and bonds are sold to investors through auctions. Sale of these instruments drain money out of the system, where as buying these items will release money into the system.

The three tools that affect the money supply will also affect three macro-economic indicators. The three indicators are the Gross Domestic Product, the Inflation Rate, and the Unemployment Rate.

1. Gross Domestic Product:

The Gross Domestic Product will increase with increasing money supply. High levels of money in the system will spur on inve...

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... for alleviating extreme inflation or depression in our economy. Each tool can affect the aggregate demand in our system, which results a change in GDP, inflation and the change in unemployment rates.

References

Federal Reserve Bank Of Dallas, (n.d.). Everyday Economics: The Federal Reserve, Monetary

Policy and the Economy. Retrieved May 11, 2007, from http://www.dallasfed.org/educate/everyday/ev4.html

Federal Reserve Bank Of San Francisco, (2006). U.S. Monetary Policy: An Introduction.

Retrieved May 12, 2007, from http://www.frbsf.org/publications/federalreserve/monetary/

Federal reserve Board, (2007). Retrieved May 11, 2007, from

http://www.federalreserve.gov/policy.htm

University of Phoenix. (2007). Monetary Policy. Retrieved May 11, 2007, from University of

Phoenix, rEsource, Simulation, MBA501—Forces Influencing Business in the 21st Century web site.