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The Federal Reserve controls the economy of the United States through a variety of tools. They use these tools to shape the monetary policy of the United States in order to promote economic growth and reduce the rate of inflation and the unemployment rate. By adjusting these tools, the Fed is able to control the amount of money in the supply. By controlling the amount of money, the Fed can affect the macro-economic indicators and steer the economy away from runaway inflation or a recession.
The Federal Reserve
The Federal Reserve uses three main tools in order to control the money supply. The first tool is open-market operations. These operations consist of the buying and selling of government bonds to commercial banks and the public. Open-market operations are the most important tool that the Fed can use to influence the money supply (Brue, 2004, p. 252). By buying bonds from the open market, the Federal Reserve increases the reserves of commercial banks which in turn will increase the overall money supply in the country. The opposite is true if the Fed sells bonds on the open market. By doing so, the Fed reduces the reserves of banks and, in turn, takes money out of the system. By being able to control how much money the commercial banks can lend, the Fed has a very powerful tool to adjust the economy.
The second tool the Federal Reserve uses is the adjustment of the reserve ratio. The reserve ratio is the ratio of the required reserves the commercial bank must keep to the bank’s own outstanding checkable-deposit liabilities (Brue, 2004, p. 254). By raising and lowering the ratio, the Fed can control how much the commercial banks can lend. For example, if the Fed lowers the reserve ratio, commercial banks will now have more excess reserves allowing them to lend more money to businesses or individuals. Vice-versa, by increasing the ratio, the Fed forces the banks to lend less money due to having smaller excess reserves. If the bank is deficient in the amount of reserves it has, the bank is forced to reduce checkable deposits and, subsequently, reduce the money supply. It may also need to increase its reserves by selling bonds, which would also lower the money supply (Brue, 2004, p. 274).
Finally, the last tool the Fed can use is to adjust the discount rate. The discount rate is the interest rate at which the Federal Reserve charges commercial banks for a loan (Brue, 2004, p.
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All of these tools allow the Federal Reserve to affect the macro-economic indicators. The three main macro-economic indicators the Fed looks at are Real Gross Domestic Product (GDP for short), Inflation Rate, and Unemployment Rate. Each one is affected by changes in the money supply in various ways. Real GDP increases when the money supply increases. With more money in the economy, investment and consumer demand rise. This leads to an increase in the Real GDP. Any measure taken by the Fed that reduces the money supply leads to a decrease in investment and spending which will lead to a decrease in the Real GDP. Although the increase in the money supply leads to an increase in Real GDP, it also leads to an increase in the rate of inflation. If the amount of money in the economy is increased, the real value of money decreases because there’s more money purchasing the same quantity of goods and services. As a result, the prices will increase and as will the rate of inflation. Finally, the unemployment rate is inversely related to Real GDP. As GDP increases, investment and spending increase, leading to greater demand and employment opportunities. As employment opportunities increase, unemployment rates drop. As would be expected, when Real GDP goes down, investment and demand will drop leading companies to slow their growth. This leads to an increase in the unemployment rate (University of Phoenix, Mone, 2008).
The primary effect of the tools the Fed can use is to create or remove money from the supply. The money is created primarily from the commercial banks issuing loans to consumers or businesses. The money for the loans comes from the excess reserves the banks have at the Federal Reserve Bank. The Federal banking system is set up in such a way where any excess reserves are magnified into a larger amount of new checkable-deposit money. This is known as the monetary multiplier (Brue, 2004, p. 262-263). It is found by taking the reciprocal of the required reserve ratio. For example, if the required reserve ratio is 10% (.1), the monetary multiplier is 10. For a $100 deposit, the banking system is legally required to keep $10 in reserve and the remaining $90 becomes available for loans. The banking system can take that $90 and create $900 of new checkable deposits, mostly through loans. Thus the banking system has created $900 of money. Extending this equation over the large number of banking systems and deposits every day, one can see that the United States banking system can create a large amount of money daily. For the profit-minded bank, they would continue to loan money in order to gain the most profit off of the interest on the loans. However, by increasing the amount of money in the supply, the rate of inflation increases. This is where the Fed steps in and uses the tools mentioned above in order to control the amount of money banks can create or force banks to withdraw money from the supply.
The Fed has the inevitable job of steering the largest economy in the world, constantly adjusting and balancing changing variables and inputs. To do this, they need a monetary policy that achieves a balance between economic growth, low inflation, and low rate of unemployment. The most obvious policy would be to increase the reserves that banks have so that they can lend more, leading to a rise in Real GDP and a lower unemployment rate as companies hire more people to meet demand. However, because inflation is directly linked to the money supply, an increase in the money supply will lead to an increase in the inflation rate. This would be unacceptable to the public because their money now buys less goods and products than before. Therefore, the Fed must strike a balance between increasing the growth and curbing rising inflation. The best policy for the Fed to enact would be one which makes gradual changes, in order to gauge the effect of the changes and to see where the economic indicators are heading. By adjusting the policy gradually, the Fed can get a better idea of how to make the next set of adjustments in order to keep inflation in check and continue the growth of the economy.
The Fed has the great responsibility of keeping the United States economy on track and running smoothly. To do so, they have three main tools at their disposal in order to affect changes in the monetary policy. Their most important tool is the buying and selling of securities on the open market. This allows the Fed to control the amount of money that is in the supply, enabling them to affect the amount of reserves commercial banks maintain. The other two tools, adjustment of the reserve ratio and the discount rate, also affect the overall money supply, however, not as effectively as the open-market operations. By changing the amount of reserves commercial banks must keep, the Fed can increase or decrease the amount of money that banks may wish to loan to consumers or businesses. If the banks increase the amount of loans they issue, they also end up creating money. The Fed, when deciding on a monetary policy, has to balance this increase in the money supply and how it affects the major economic indicators of Real GDP, inflation, and unemployment. By creating a balanced monetary policy, the Fed can effectively continue economic growth while lowering inflation and the unemployment rate.
Brue, Stanley L. and McConnell, Campbell, R. (2004). Economics: Principles, Problems
University of Phoenix. (2003). Monetary Policy [Computer Software]. Retrieved June 2, 2008, from University of Phoenix, rEsource, Simulation, MBA 501: Forces Influencing Business in the 21st Centrury. Web site.