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Monetary policy is the process governments and central banks use to manipulate the quantity of money in the economy to achieve certain macroeconomic and political objectives. The objectives are economic growth, changes in the rate of inflation, higher level of employment, and adjustment of the exchange rate. Monetary policy is categorized into two types; concrationary and expansionary. Concrationary (tight) monetary policy aims to reduce the amount of money circulating through the economy, and reduce short-term economic growth in exchange for higher (hoped-for) long-term growth. Expansionary (lose) policy, on the other hand, aims to increase the money supply and increase short-term economic activity at the expense of long-term economic activity. (Nematnejad, Aaron, 2008)
The primary measure of the economy’s performance is the annual total output of goods and services, or as the process is called, the aggregate output. Aggregate output is labeled gross domestic product (GDP): the total market value of all final goods and services produced in a given year. (McConnell and Bure, 2004). The monetary value of all the finished goods and services produced within a country's borders in a specific time frame, though GDP is usually calculated on an annual basis. It includes all private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.
GDP = C + G + I + NX
"C" is equal to all private consumption, or consumer spending, in a nation's economy.
"G" is the sum of government spending.
The gross discount product is commonly used as an indicator of the economic health of a country, to gauge a country's standard of living. Critics of using the gross discount product as an economic measure say the statistic does not take into account the underground economy - transactions that for whatever reason, are not reported to the government. Others say that the gross discount product is not intended to gauge material well-being, but serves as a measure of a nation's productivity, which is unrelated.
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The unemployment rate tells macroeconomists the percentage of the total workforce that is unemployed, however, the people are actively seeking employment and willing to work. Measuring the employment rate is done by first determining who is eligible and available to work; these people are considered potential members of the workforce or group one. Group two is comprised of those people not employed but not seeking work. The third group is called the labor force; in 2002 this was approximately 50% of the population. (McConnell & Brue, 2004) Macroeconomists agree that when the economy has experienced growth from time to time, which is identified in the gross discount product growth rate, unemployment levels are seemingly low. The reasoning behind this is the rising of gross discount product levels. Knowing if the output is higher the more laborers are needed to keep up with the higher levels of production. However, when the levels of gross discount products are low, the rate of unemployment rises and potential goods and services are lost.
The third main factor that macroeconomists look at is the inflation rate, or the rate at which prices rise. Inflation is primarily measured in two ways: through the Consumer Price Index (CPI) and the Gross Discount Product deflator. The Consumer Price Index gives the current price of a selected basket of goods and services that is updated periodically. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living. The GDP deflator is the ratio of nominal GDP to real GDP. The GDP deflator shows how much a change in the base year's GDP relies upon changes in the price level. This is also known as the “GDP implicit price deflator.” (Hekal, Reem, 2008)
The most powerful weapon in the Fed’s arsenal is the ability to influence the direction of interest rates. Interest rates are the yearly prices charged by a lender to a borrower in order for the borrower to obtain a loan. This is usually expressed as a percentage of the total amount loaned. When interest rates are low, capital is easier to acquire. This can spur economic development because, human nature being what human nature is, the more cash that is available to spend, the more likely the item being purchased will be purchased with cash at that moment; however, this leads to inflation, as businesses realize they can charge higher prices for their goods and services. Suddenly, everything cost more. (Kennon, Joshua, 2008) With the increase in prices the need for more money becomes a huge demand for the consumer.
The matter of money creation is poorly understood. A common misconception is that banks or governments create money. Governments only borrow money into existence from the banks. Banks can and do manage and redistribute money and wealth. Only people and natural resources represent potential wealth. Only people can, by their labor, produce useful wealth, which can be traded, either 1) directly by barter, 2) through the use of currency, or 3) through the creation of money. Remember, all people who buy or sell are producers or consumers, are traders. (Kurmm, Paul, 2007)
Money is created when a trader makes a commitment, by buying goods or services from other traders, to place goods or services in the marketplace of equal value. In making purchases, traders borrow against their future production if they do not currently have a trading surplus. Money is created as evidence of that debt. Putting goods and services back on the market repays the debt and extinguishes the money. In other words, money is borrowed into existence and is extinguished as the loan is repaid. The effective lender, or guarantor of a loan is all the traders who trade with the borrower in short the community; the market. (Kurmm, Paul, 2007).
Another way of explaining how money is created is, if a bank makes a loan, nothing is lent, for the simple reason that nothing of substance is being lent. The bank makes what it terms a loan against the amount of money deposited with it at that time. This is all done with the utmost ease. The bank has simply to agree that a person may take out a loan of, say, $5,000. The person taking out the loan can then spend $5,000 and hey presto! $5,000 of new number-money has been created. No one with a bank account is sent a letter telling them that the money in their account is temporarily unavailable, because it has been lent to someone else. None of the original accounts in the bank has been touched, reduced or affected. Nobody else's spending power has been reduced, but $5,000 of new spending power has been created; $5,000 of new number-money enters the economy at the stroke of a bank manager’s pen, but $5,000 of debt has also been created. Thus, whoever takes out the loan will then make purchases and payments to other people, who will pay that new money into their bank accounts. Result: more bank deposits! As soon as the loan in the example above is spent, $5,000 will find its way into the bank account of a car dealer or department store; $5,000 of apparently new money. This is money which has supposedly been loaned but the banking system doe not distinguish this fact. It simply registers a new deposit, and regards it as new money. Total deposits in the banking system have therefore, increased by $5,000. This is the boomerang effect of a bank loan by which a loan rapidly creates an equivalent amount of new bank deposits in the banking system. This effect was neatly summarized in a statement by Graham Towers, former Governor of the Central Bank of Canada.... "Each and every time a bank makes a loan; new bank credit is created -- new deposits -- brand new money." The new money will provide the banking system with the collateral for more lending. This is the bolstering effect of a bank loan. As the total money held by banks and building societies becomes swollen by loans returning as new deposits this provides them with the basis for future loans.
To promote balance between aggregate demand and potential supply and to contain inflation pressures, the Federal Open Market Committee (FOMC) took additional firming actions this year, raising the benchmark federal funds rate 1% point between February and May. The tighter stance of monetary policy, along with the ongoing strength of credit demands, has led to less accommodative financial conditions: On balance, since the beginning of the year, real interest rates have increased, equity prices have changed little after a sizable run-up in 1999, and lenders have become more cautious about extending credit, especially to marginal borrowers. Still, households and businesses have continued to borrow at a rapid pace, and the growth of M2 remained relatively robust, despite the rise in market interest rates. The favorable outlook for the U.S. economy has contributed to a further strengthening of the dollar, despite tighter monetary policy and rising interest rates in most other industrial countries. (Financial Services, 2000)
In conclusion, the reader should have a better understanding of what monetary policy is and the effect monetary policy has on macroeconomic facts such as gross discount products (GDP), unemployment, inflation, and interest rates. The reader should also have a better understanding on how money is created and which policies create the best balance for economic growth, low inflation, and a reasonable rate of unemployment.
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