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The monetary policy consists of three tools used by the Federal Reserve, also known as the Fed, to control the money supply; open-market operations, reserve ratio, and the discount rate. These tools influence the money supply and in turn affect macroeconomic factors such as the gross domestic product (GDP), the unemployment rate, the inflation rate, and the interest rate. gMost economists believe that monetary policy influences economic activity and prices by affecting the availability and cost of money and credit to producers and consumers.h (Meulendyke, 1998, p. 189). The goal of the Fed is to use the correct combinations of monetary policies to achieve a balance between economic growth, low inflation, and a reasonable rate of unemployment.
Federal Reserve Tools
The Fed uses the publicly traded (open) market to buy and sell government securities to and from commercial banks and the public. There are three common types of government securities; bonds, notes, and bills issued by the U.S. Treasury and managed through the Fed. The Fed issues new treasury bonds and notes through the Treasury Direct program and issues new treasury bills (T-Bills) at auction at any Federal Reserve Bank. The Fedfs open-market committee (FOMC) meets regularly to evaluate the economy and decide whether to buy or sell securities therefore, changing the supply of money in circulation. gOpen-market operations are the Fedfs most important instrument for influencing the money supply.h (McConnell & Brue, 2004, p. 270).
The Fed uses the open-market operations tool frequently to influence the economy in the direction the FOMC has decided. The GDP, inflation rate, and unemployment rate are key macroeconomic indicators affected by the decisions of the FOMC. When the FOMC decides to buy securities the committee is trying to boost the economy. The GDP gthe total market value of all final goods and services produced in a given yearh (McConnell & Brue, 2004, p. 112) will increase as money enters the economy and businesses borrow that money to produce and sell products. The more money that enters the economy the more the inflation rate will rise because there is an excess amount of money compared to the supply of goods and services created. The unemployment rate will decrease because the money enters the economy stimulating businesses to borrow and purchase the resources (people) to produce products.
On the contrary, when the FOMC decides to sell securities the committee is trying to slow down the economy by taking money out of circulation that would otherwise be available for use in the economy.
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The Fed also uses the reserve ratio to control how much money is available to the economy. The Fed requires every bank that is a member of the Federal Reserve System to keep a percentage of deposits on hand and available to its customers. That percentage is set by the Fed and is typically around 10% of the total banks deposits. Therefore, gthe Fed can also manipulate the reserve ratio in order to influence the ability of commercial banks to lend.h (McConnell & Brue, 2004, p. 273). Adjusting the reserve ratio along with buying and selling securities on the open-market the Fed can manipulate the economy in any direction it desires.
Increasing the reserve ratio has a similar effect of selling securities on the open-market. Both of these actions result in less money available for banks to lend to its customers. Therefore, the GDP declines because there are fewer funds available to create products. Inflation also declines since there is less money available compared to the supply of goods and services created. Conversely the unemployment rises because there is less money available and businesses make less and need fewer people.
Decreasing the reserve ratio has a similar effect of buying securities on the open-market. Both of these actions result in more money available for banks to lend to its customers. Therefore, the GDP increases when more funds are available and production rises. Since production increases the need for more workers increases and therefore, the unemployment rate decreases. Whenever the GDP increases inflation is bound to follow. gIncreasing the money supply will increase the rate of inflation. Herefs how: when the amount of money in the system is increased, the nominal value of money remains the same, but, as more money chases the same quantity of goods and services, the real value of money is decreased. As a result, prices go up, thereby signaling greater inflation rates.h (University of Phoenix, 2007).
The third tool used by the Fed to control the money in circulation is the discount rate (DR). The DR is the rate at which the Fed lends money to the banks. gJust as commercial banks charge interest on their loans, so too Federal Reserve Banks charge interest on loans they grant to commercial banks. The interest rate they charge is called the discount rate.h (McConnell & Brue, 2004, p. 274). When banks are needing to borrow money to increase their ability to lend and create money they compare the DR charged by the Fed to the rate banks charge each other, the federal fund rate (FFR). The Fed cannot change the FFR directly but uses the DR along with the reserve ratio and open-market monetary policies to affect the FFR to meet its goals.
Increasing the DR will have a similar effect of selling securities on the open-market. The increased DR will make borrowing money from the Fed undesirable and therefore, reduce the amount of available lending funds banks can offer to its customers. Since there is less money to lend the result will be a lower GDP, lower inflation, and higher unemployment. The Fed would increase the DR when it wanted to slow down the economy.
Conversely, decreasing the DR will have a similar effect of buying securities on the open-market. The decreased DR will be an incentive for banking institutions to borrow more money at the cheaper rate. This will cause more money to be available to lend to its customers. Therefore, the GDP increases since businesses have more money to create and produce more products. This will also cause inflation to rise as inflation tends to follow the same direction as the GDP. Unemployment decreases when the GDP increases. This is because additional employees are required to produce more products.
Money is created when the Fed buys securities on the open-market. gThe money that pays for the securities hasnft existed before, but it has value, or worth, because the securities the Fed has bought with it are valuable.h (Morris & Morris, 1999, p. 17). The Fed pays for the securities to the brokerage house which deposits the money into its bank. That bank then has more money to lend to its customers. That customer will purchase a product with those borrowed funds and the seller of that product will deposit those funds into their own bank. Then that bank will have more money to lend to its customers. This cycle can repeat itself several times expanding the money created each time.
Suppose the Fed had decided to boost the economy by buying 100,000 dollars in securities from bank A and the current reserve ratio was 10%. Bank A would deposit the 100,000 received from the Fed into their bank, holding 10,000 of that deposit in reserve as required by the reserve rate, leaving 90,000 available to lend to its customer. A couple decides to buy a house and comes to bank A to borrow 90,000. The seller of this home receives 90,000 dollars and deposits the check into bank B. Now bank B has 90,000 dollar deposit but must hold 9,000 (10%) in reserve, leaving 81,000 available to lend to its customers who they did not have before. A business man decides to buy that dream car and goes to bank B and borrows 81,000 dollars. The dealer who sold the car now has a check for 81,000 and deposits the money into bank C. Bank C now has received 81,000 dollars in deposits and must hold 8,100 in reserve and therefore, has 72,900 dollars available to lend to its customers who they did not have before. These four simple steps have created 343,000 dollars of new money in the economy that did not exist before.
Recommended Monetary Policy
To resolve the complicated combinations of monetary policy that best achieves a balance between economic growth, low inflation, and a reasonable rate of unemployment the Fed will invoke an easy or tight money policy. The Fed will typically set a goal for the FFR and manage the fluctuations in the economy accordingly to meet that goal. At the January, 2007 FOMC meeting the committee discussed the recent developments and the projected outlook of the economy concluding with the following directive:
The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5-1/4 percent. (Reinhart, 2007, p. 21).
This directive will invoke at times both an easy and tight money policy to maintain the FFR of 5-1/4 percent. Table 1 shows the effects of the monetary policy with regard to the key macroeconomic indicators that measure the stability and growth of the economy.
Easy Money Policy Tight Money Policy
Buy Securities Decrease Reserve Rate Decrease DR/FFR Ratio Sell Securities Increase Reserve Rate Increase DR/FFR Ratio
GDP Increase Increase Increase Decrease Decrease Decrease
Inflation Increase Increase Increase Decrease Decrease Decrease
Unemployment Decrease Decrease Decrease Increase Increase Increase
At the January FOMC meeting the participants reviewed the current indicators and projected the outlook of the economy and noted gthe prevailing level of inflation was uncomfortably high, and resource utilization was elevated.h (Reinhart, 2007, p. 17). This revelation would indicate the Fed would implement a tight money policy to curb the inflation rate while keeping a close watch on the FFR. The unfortunate side effects would also include a decrease in the GDP and in increase in the unemployment rate.
The Fed has a difficult task of balancing these factors to keep the U.S. economy growing, keeping inflation, and unemployment under control. By understanding the effects of the monetary policy, decisions made by the Fed keep the economy stable and flourishing. gThe Federal Reserve has continued to seek price stability and sustainable economic growth. Indeed, the experiences of the last few decades have emphasized the importance of eliminating inflation and adhering to a policy that promotes prolonged price stability.h (Meulendyke, 1998, p. 221). The task of the Fed is challenging to say the least. The world watches the U.S economy and the actions of the Fed. The U.S. economy is such an economic force on the global economy.
McConnell, C & Brue, S. (2004). Economics: Principles, Problems and Policies, 16e. New York: The McGraw-Hill Companies.
Meulendyke, A. M. (1998). U.S. Monetary Policy & Financial Markets, New York: Federal Reserve Bank of New York.
Morris, K. M. & Morris V.B. (1999). The Wall Street Journal: Guide to Understanding Money and Investing. New York: Lightbulb Press, Inc.
Reinhart, V. R. (2007). Minutes of the Federal Open Market Committee, January 30-31, 2007. Retrieved April 26, 2007, from State of the Nation database website: http://www.stat-usa.gov.ezproxy1.apollolibrary.com/ONLINE.NSF/vwNoteIDLookup/NT007D0A96/$File/FOMC200701.DOC?OpenElement.
University of Phoenix, (2007). Monetary Policy [Computer Software]. Retrieved April 26, 2007, from University of Phoenix, Resource, Simulation, MBA501Forces Influencing Business in the 21st Century Web site: https://mycampus.phoenix.edu/secure/resource/vendors/tata/sims/economics/economics_simulation3.html.