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This paper will discuss the objective of monetary policy and its influence on the performance of the economy as it relates to such factors as inflation, economic output, and employment. Monetary policy affects all kinds of economic and financial decisions people make in this country, whether to get a loan to buy a new house or car or to start up a company, whether to expand a business and whether to put savings in a bank, in bonds, or in the stock market. Furthermore, because the U.S. is the largest economy in the world, its monetary policy also has significant economic and financial effects on other countries.
According to the Purposes and Functions of the Federal Reserve System, monetary policies are spelled out in the Federal Reserve Act. Monetary policy is conducted by the nation's central bank, the Federal Reserve System (Fed). According to Brue & McConell, the Fed has three tools of monetary control it can use: open market operations, reserve ratio/requirement and discount ratio.
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- Macroeconomic Impact on Business Operations This paper will discuss the objective of monetary policy and its influence on the performance of the economy as it relates to such factors as inflation, economic output, and employment. Monetary policy affects all kinds of economic and financial decisions people make in this country, whether to get a loan to buy a new house or car or to start up a company, whether to expand a business and whether to put savings in a bank, in bonds, or in the stock market.... [tags: Economics Macroeconomics Business]
1832 words (5.2 pages)
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- Abstract This paper focuses on Monetary Policy, which centers on connections between money, banks, and credit to lenders. In addition, this paper will cover the effect on macroeconomic factors such as GDP, unemployment, inflation, and interest rates. Additionally, an explanation on money creation and the implications of making money gives an insight on Money Supply and Macroeconomic Factors. With many combinations of monetary policy, the paper covers the optimal balance between economic growth, low inflation, and a reasonable rate of unemployment.... [tags: Business Economics ]
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When prices are stable and believed likely to remain so, the prices of goods, services, materials, and labor are not distorted by inflation and therefore contribute to higher standards of living. Additionally, stable prices foster saving and capital formation, because when the risk of erosion of asset values resulting from inflation and the need to guard against such lossesare minimized, households are encouraged to save more and busi¬nesses are encouraged to invest more (Board, n.d.).
Beyond influencing the level of prices and the level of output in the near term, the Fed can contribute to financial stability and better economic performance by containing financial disruptions and pre¬venting their spread outside the financial sector. Modern financial systems are complicated and may be vulnerable to wide-scale systemic disruptions. The Fed enhances the financial system's resilience to these types of disruptions through regulatory policies geared at banking institutions and payment systems. If a threatening disturbance develops, the Fed also cushions the impact on financial markets and the economy by aggressively and visibly providing liquidity through open market operations or discount lending.
The Federal Open Market Committee (FOMC) exercises a great deal of control over the federal funds rate through its influence over the supply of and demand for balances at Federal Reserve Banks. The initial link in the chain between monetary policy and the economy is the market for balances held at the Federal Reserve Banks. The FOMC sets the federal funds rate at a level it believes will foster financial and monetary conditions consistent with achieving its monetary policy objectives, and it adjusts that target in line with evolving economic developments. A change in the federal funds rate, or even a change in expectations about the future level of the federal funds rate, can set off a chain of events that will affect short-term and long-term interest rates, the foreign exchange value of the U.S. dollar, and stock prices. In turn, changes in these variables will affect spending decisions, thereby affecting growth in aggregate demand and the economy.
Short-term interest rates are affected not only by the current level of the federal funds rate but also by expectations about the overnight federal funds rate over the duration of the short-term contract. As a result, short-term interest rates could decline if the Fed surprised market participants with a reduction in the federal funds rate, or if unfolding events convinced participants that the Fed was going to be holding the federal funds rate lower than had been anticipated.
Long-term rates are affected not only by changes in current short-term rates but also by expectations about short-term rates over the rest of the life of the long-term contract. Generally, economic news or statements by officials will have a greater impact on short-term interest rates than on longer rates because they typi¬cally have a bearing on the course of the economy and monetary policy over a shorter period; however, the impact on long rates can also be con¬siderable because the news has clear implications for the expected course of short-term rates over a long period.
Changes in long-term interest rates also affect stock prices, which can have a pronounced effect on household wealth. Investors try to keep their investment returns on stocks in line with the return on bonds, after allow¬ing for the greater risks of stocks. For example, if long-term inter¬est rates decline, then, all else being equal, returns on stocks will exceed returns on bonds and encourage investors to purchase stocks and bid up stock prices to the point at which expected risk-adjusted returns on stocks are once again aligned with returns on bonds. Moreover, lower interest rates may convince investors that the economy will be stronger and profits higher in the near future, which should further lift equity prices. If the economy is showing signs of overheating and inflation pressures are building, the Fed will be inclined to counter these pressures by tightening monetary policy.
Another determining factor of inflation is the rise or fall of the unemployment rate. If the unemployment rate is very high or low relative to historical experience, the implications for future inflation are fairly obvious. However unemployment rates in the intermediate range are usually difficult to interpret.
Money is created in two ways: from borrowing it and spending it. Second, it can simply be printed up "out of thin air" by a central bank (Benson, 2004). The U.S. economy and other modern economies have central banks and flat currencies. Central banks have two major powers. According to Benson, central banks can 1) "peg" the nominal level of short-term interest rates, and 2) purchase assets such as government debt, with newly printed money. When the central bank pegs short-term interest rates at a low level, it encourages borrowing and spending.
For the past ten years, money has been created through private sector borrowing and spending. However, there will come a day when the private sector's new borrowing will not create enough new money to keep servicing the massive level of old debt. Central banks will need to step up their efforts to print money out of thin air which can be accomplished by purchasing government debt or other assets.
Without inflation, there remains a risk of deflation. If old debt is paid down, or forgiven in bankruptcy, money that has been previously created will vanish. If the money and debt goes, asset prices will collapse. Many intellectual writers have concluded that rising interest rates will cause a "deflationary debt collapse" as interest rates rise (Board, n.d.). Certainly, a rise in interest rates to more normal levels will cause some financial distress. Moreover, a rise in interest rates tends to slow the private money creation process.
Let's not forget that central banks can create new money with a few strokes at a computer keyboard to purchase whatever assets they wish. The Fed can create any volume of money it needs to keep the economy servicing both old and new debts. It seems virtually certain that the Fed, and other friendly central banks, will print as much new money as they need to because inflation tomorrow is better than a collapse of the financial system today (Board, n.d.).
All of the guides and tools discussed have something to do with the transmission of monetary policy to the economy. All have cer¬tain advantages; however, none has shown so consistently close a relation¬ship with the ultimate goals of monetary policy that it can be relied on alone. Each of the tools does however, serve a purpose however when combined, become more effective and consistent. Consequently, monetary policy makers have tended to use a broad range of indicators to judge trends in the economy and to assess the bearing of monetary policy (Board, n.d.).
Such an eclectic approach enables the Fed and central banks to use all the available information in conducting monetary policy. This tactic may be especially important as market structures and economic processes change in ways that reduce the utility of any single indictor. However, a downside to such an approach is the difficulty it poses in communicating the central bank's intentions to the public; the lack of a relatively simple set of procedures may make it difficult for the public to understand the actions of the Fed and to judge whether those actions are consistent with achieving its statutory goals. This downside risk can be challenged if the central bank develops a track record of achiev¬ing favorable policy outcomes when no single guide to policy has proven reliable.
The long-term goal of the Fed's monetary policy is to ensure that money and credit grow sufficiently to encourage non-inflationary economic expansion. The Fed cannot guarantee that our economy will grow at a healthy pace, or that everyone will have a job. Achievement of this depends on the decisions of millions of people in this country. Decisions regarding how much to spend and how much to save, how much to invest in acquiring skills and education, how much to spend on new plant and equipment, or how many hours a week to work may be some of them. What the Fed can do, however is to create an environment that is conducive to healthy economic growth by pursuing a goal of price stability by trying to prevent inflation from becoming a problem.
Benson, Richard. (2004). Money created out of thin air. Vronsky and Westerman. Retrieved
November 26, 2006, from http://www.gold-eagle.com/editorials_04/benson073004.html.
Board of Governors of the Federal Reserve System. (n.d.). The Federal Reserve System Purposes and Functions. System Publication. Retrieved November 26, 2006 from http://www.federalreserve.gov/pf/pdf/pf_complete.pdf.
Brue, S. and McConnell, C., (2004). Economics: Principles, Problems and Policies. The