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In the “Monetary Policy” simulation you are appointed the new chairman of The Fed by the President of the United States. Your first order of business is to implement an appropriate monetary policy. The simulation begins in 2004 and carries through to 2010 and each year you must decide what the spread between DR (Discount Rate) and FFR (Federal Funds Rate) will be, what the RRR (Required Reserve Ratio) of the banks will be as well as monitoring the OMO (Open Market Operations).
The Discount Rate (DR) is the rate charged by the Fed for borrowing money, while the FFR is the rate charged for money borrowed by other banks. According to the simulation, if the rate of the DR is lower than that of the FFR, banks are more inclined to borrow from The Fed. When this happens, the supply of money in the system is increased whereas when banks borrow from other banks the supply of money is unchanged. “An increase in the discount rate discourages commercial banks from obtaining additional reserves through borrowing from Federal Reserve Banks. So the Fed may raise the discount rate when it wants to restrict the money supply,” (McConnell & Brue, p. 11).
The Required Reserve Ratio is the actual money, or cash money, that banks are required to have on hand. If the RRR is low it allows the banks to lend more, therefore putting more money into the economy. In reverse, if the RRR is high, the banks are limited on the amount of loans they can approve and therefore limit the amount of money put into the system. For example, Bank A’s actual reserves are $10,000 and the checkable deposits are $50,000.
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The Open Market Operations (OMO), as explained in the simulation, is t-bills and bonds that can be bought and sold to increase the money supply in the economy. These bonds can be bought from or sold to the general public or commercial banks. “Open-market operations are the Fed’s most important instrument for influencing the money supply,” (McConnell & Brue, p. 3). “The Fed's control over the money supply stems from its ability to change the composition of its balance sheet. For example, the Fed may decide to purchase additional government bonds on the open market from bondholders or private banks,” (CliffsNotes, ¶ 11).
Each of these factors is used by The Fed to either increase or decrease the supply of money in the economy which, in turn, affects the GDP, inflation and unemployment rate. The more accessible money in the economy, the more likely the rate of inflation will increase. However, when more money is available and people are able to spend, this will also lower the unemployment rate due to the fact that workers are needed to meet the demand of consumer buying. In the same respect, if money is less accessible and people are not spending, the unemployment rate will increase and inflation and the GDP will decrease.
The creation of money most often comes from the banks through loans that they provide to the public and other banks. The Fed requires that each financial institution retain a certain amount of actual cash for reserves, and “has the authority to establish and vary the reserve ratio within limits legislated by Congress,” (McConnell & Brue, p. 4). However, the actual creation of “new” money comes from the Treasury. “The U.S. Bureau of Engraving creates the Federal Reserve Notes and the U.S. Mint creates the coins,” (McConnell & Brue, p. 1). The way the banks “create” money is by loaning it to individuals to put back into the economy since “currency held by a bank, you will recall, is not part of the economy’s money supply,” (McConnell & Brue, p. 4).
The “Monetary Policy” simulation provided the user an opportunity to play with the figures for the Required Reserve Ratio, Federal Funds Rate and Open-market Operations and see how they affected the macroeconomic factors of GDP, inflation and unemployment rate. However, my experience was that there was no set system for increasing GDP, lowering inflation and keeping unemployment at a manageable rate. It became apparent rather quickly that most often, when GDP increased so did inflation. It was noticeable early on that keeping the GDP at a promising level and sustaining the unemployment rate within an acceptable range was fairly easy. However, the most difficult task proved to be keeping the inflation rate from getting out of control. Ideally, lowering the rate of unemployment was achieved by flooding the market with money which also increased the GDP but caused the inflation rates to increase as well. “Inflation is a rise in the general level of prices. When inflation occurs, each dollar of income will buy fewer goods and services than before. Inflation reduces the ‘purchasing power’ of money,” (McConnell & Brue, p. 18).
Towards the end of the simulation, I realized that if I increased the spread between the DR and FFR, usually around a -1 to -1.5, but sold in the Open-market operations it helped to increase the GDP, level out the inflation and lower the unemployment rate. Occasionally when adjusting those two factors did not work the way I wanted or expected, a slight adjustment to the RRR would produce the desired affect.
In conclusion, it is easy to see how the tools used by the Federal Reserve to control the money supply can affect the macroeconomic factors of GDP, inflation and the unemployment rate but are not as easily predicted. The more one examines the trends of these macroeconomic factors the more their correlation to the money supply becomes more prevalent. However, it is quite apparent that one unexpected occurrence could cause a serious blow to our country’s economic stability and cause the Fed to scramble to regain control. There is no set formula or indisputable equation to the success or failure of this country’s economy for, if there were, there would be no poverty, no unemployment and no National Deficit.
CliffsNotes.com. Supply of Money. Retrieved October 22, 2007, from http://www.cliffsnotes.com/WileyCDA/CliffsReviewTopic/topicArticleId-9789,articleId-9747.html
FED101. Money. Retrieved October 22, 2007 from
McConnell, B. and Brue, S. (2004). Economics: Principles, Problems, and Policies. New York: McGraw Hill.