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In order to achieve stability in the nation's economy, the creation of a centralized banking system was put into place to target double digit inflation. The Federal Reserve System was created 1913 with the hopes of increasing the supply of currency.
Monetary policy is the process by which the government, central bank or monetary authority manages the money supply to achieve specific goals. These goals include constraining inflation, maintaining an exchange rate, achieving full employment or economic growth (Monetary policy, Wikipedia). There are two forms of monetary policy, expansionary and contractionary policy. In expansionary policy, the Federal Reserve Bank ("Fed") is used to fight unemployment by lowering its interest rates and to increase the supply of money. In order to do this, the Fed will buy securities, lower the reserve ratio or lower the discount rate. Its purpose is to make bank loans less expensive and more available which increases the aggregate demand, output and employment. In contractionary policy, the Fed will try to reduce the aggregate demand by limiting the supply of money as well raising interest rates to fight inflation. The characteristics are opposite of expansionary policy. The Fed will sell securities, increase the reserve ratio and raise the discount rate. This is done to try to achieve the tightening of money in order to reduce spending and control inflation (McConnell & Brue, 2004, pp 11-12).
There are 12 regional Federal Reserve Banks in the United States, which were established by Congress to operate as the arms of the nation's central banking system. They are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Lois, Minneapolis, Kansas City, Dallas and San Francisco (Federal Reserve System).
The Federal Reserve currently has two legislated goals; they are price stability and full employment. In 1978, the Federal government was charged with promoting full employment and reasonable price stability by the Full Employment and Balanced Growth Act (Thorbecke, 2002, p. 255). One of the reasons in which the government should continue to give emphasis to full employment is that under the mandate, the U.S. has experienced low unemployment and low inflation. Secondly, the costs of unemployment are known to be considerable. Thirdly, central bankers tend to be inflation-averse and occasionally need to be prodded to pursue goals other than reducing inflation.
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The Federal Reserve has three main tools for maintaining control over the supply of money and credit in the economy. The most important tools are known as open market operations, or the buying and selling of government securities. In order to increase the supply of money in the United States, the Federal Reserve purchases government securities from banks, other businesses, or individuals, paying for them with a check, which has been instituted as a new source of money the Fed prints. When the Fed's checks are deposited into banks, they create new reserves. A portion of which banks can lend or invest, thereby increasing the amount of money in circulation. If the Fed wishes to reduce the money supply, it sells government securities to banks, collecting reserves from them. Due to the fact that they have lower reserves, banks must reduce their lending, and the money supply decreases accordingly (U.S. Department of State).
The Fed also can control the supply of money by specifying what reserves deposit-taking institutions must set aside either as currency in their vaults or as deposits at their regional Reserve Banks. Raising reserve requirements forces banks to withhold a larger portion of their funds, thereby reducing the supply of money, while lowering requirements works the opposite way to increase the money supply. Banks often lend each other money over night to meet their reserve requirements. The rate on such loans, known as the "federal funds rate," is a key gauge of how "tight" or "loose" monetary policy is at a given moment (U.S. Department of State).
By manipulating the federal funds rate, the Fed can affect inflation and unemployment. The Fed sets a target value for the federal funds rate and then alters the amount of reserves in the banking system to trigger the federal funds rate to move toward the target value. When the rates increase, the dollar tends to appreciate. The increase in long-term rates reduces spending. As spending declines, employment, output and inflation declines as well (Thorbecke, 2002, p. 256).
The Fed's third tool is the discount rate, or the interest rate that commercial banks pay to borrow funds from Reserve Banks. By raising or lowering the discount rate, the Fed can promote or discourage borrowing and thus alter the amount of revenue available to banks for making loans. The Federal Reserve System usually adjusts the federal funds rates by 0.25% or 0.50% at a time. From early 2001 to mid 2003, the Fed lowered its interest rates 13 times, from 6.25% to 1.00%, to fight recession (Federal Reserve System, Wikipedia).
These tools allow the Federal Reserve to expand or contract the amount of money and credit in the U.S. economy. If the money supply rises, credit is said to be loose. In this situation, interest rates tend to drop, business spending and consumer spending tend to rise, and employment increases; if the economy already is operating near its full capacity, too much money can lead to inflation, or a decline in the value of the dollar. When the money supply contracts, on the other hand, credit is tight. In this situation, interest rates tend to rise, spending levels off or declines and inflation abates; if the economy is operating below its capacity, tight money can lead to rising unemployment (U.S. Department of State).
Creation of Money
Today, in its most basic form, money consists of coins and paper currency. Coins come in various denominations based on the value of a dollar: the penny, the nickel, the dime, the quarter, the half dollar, and the dollar coin. Paper money comes in denominations of $1, $2, $5, $10, $20, $50, and $100 (U.S. Department of State). Money is used in transactions consisting of three kinds: (1) currency, (2) demand deposits, and (3) other checkable deposits, such as negotiable order of withdrawal (NOW accounts (Federal Reserve Bank of Chicago).
Money is measured only in terms of what it can buy. It derives its value from its scarcity in relation to its usefulness. A change in the quantity of money originates with the actions of the Federal Reserve System, depository institutions, or the public. The actual process of money creation takes place in banks. Checkable liabilities of banks are money; the liabilities are customer's accounts. The accounts increase when deposits of currency and checks are made deposited (Federal Reserve Bank of Chicago).
When legal reserve requirements are not present, banks can build up their deposits by increasing loans and investments as long as they have enough currency on hand to redeem any amounts the holders of deposits want to convert into currency. In early banking, bankers would charge a safekeeping charge for customers for gold an coins they deposited. Customers would redeem their deposits slips; physically take the gold coins as needed. It was soon found to be easier to exchange their deposit slips in lieu of the physical coins. The receipts which became known as bank notes were considered as "money". Bankers eventually discovered that they could make loans merely by giving their promises to pay. In this way, banks began to create money (Federal Reserve Bank of Chicago).
In running the Monetary Policy over a 10 year period, I was successful in steering the economy in increasing the Real GDP, lowering inflation and unemployment. I was able to achieve this during the course of the simulation by lowering the Discount Rate charged by the Federal Reserve, lowering the deposits the banks held in it reserves and either buying or selling open market operations depending on the situation. For example, during the European Economic Crisis, I set the DR-FFR spread to -1.1%, set the RRR to 10.2% and set the OMO to sell at $250 million. This provided me with a Real GDP of 3.38%, Inflation rate of 4.69% and an overall unemployment rate of 6.07%. At the end of ten years, and making several adjustments to the DR-FRR, RRR and OMO, I was able release money into the system creating a Real GDP of 3.61%, inflation of 5.1% and an unemployment rate of 5.84%.
Since the inception of the Federal Reserve System in 1913, it has come a long way in trying to stabilize the economy, decrease inflation and try to keep unemployment at low rates. Although we have seen periods of high inflation and unemployment over the past several decades, the economy is becoming more and more stable.
Federal Reserve System. Wikipedia Encyclopedia. Retrieved February 18, 2007 from http://en.wikipedia.org/wiki/Federal_Reserve_System
Modern Money Mechanics: A Workbook on Bank Reserves and Deposit. Federal Reserve Bank of Chicago. Retrieved February 18, 2007 from http://www.worldnewsstand.net/money/mmm2.html
Monetary Policy. Wikipedia Encyclopedia. Retrieved February 17, 2007 from http://en.wikipedia.org/wiki/Monetary_policy
United Stated Department of State. Outline of the US Economy. Retrieved on February 18, 2007 from http://usinfo.state.gov/products/pubs/oecon/chap7.htm
Thorbecke, W. (2002). A Dual Mandate for the Federal Reserve: The Pursuit of Price Stability and Full Employment. Eastern Economic Journal, Vol. 28, No. 2, Spring 2002. Retrieved February 19, 2007 on EBSCOhost.
Brue, S. and McConnell, C.R. (2004). Economics: Principles, Problems and Policies (16th ed.). New York: McGraw-Hill. Retrieved on February 13, 2007 from the University of Phoenix Library.