Monetary Policy

According to the Federal reserve website the definition of monetary policy refers to the "actions of the Federal reserve to influence the availability and cost of money and credit to help to help promote national economic goals," (www.federalreserve.gov). The tools used to balance the money supply are discount rates, required reserve ratio and open market operations. In 1913 the Federal Reserve took responsibility for setting the monetary policy (www.federalreserve.gov). When originally developed its purpose was to maintain the gold standard, today the responsibility is much more complex. Using the tools named above the Federal Reserve controls the demand, supply and balances banks must hold in their depositories, this in turn results in the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depositories institutions over night. The changes in the federal funds reserve cause a long chain of events such as short term and long term interest rates, the amount of money and credit available as well as changes in employment rates, inflation rates and gross domestic product fluctuations. To better understand the effects of the discount rate, federal funds rate, required reserve ratio and open market operations have on controlling the money supply I completed a simulation called Monetary Policy on the University of Phoenix website. Observations from the simulation will be used throughout this paper.

The Federal Reserve maintains control over the amount of excess reserves it requires lenders to have to promote continued flow of money. The three tools mentioned above that the Federal reserve uses to control the required amount of excess reserves are the discount rates, required reserve ratio and open market operations. The discount rate is the rate at which banks can borrow money from the Federal Reserve. The rate rarely changes; its purpose is security for banks to avoid insufficient funds. The simulation provided an example of how the spread between the federal funds rate and the discount rate can affect the trend banks use when borrowing. If the discount rate interest is lower than the federal funds ratio banks are more inclined to shift their borrowing to the Federal Reserve which increases the total amount of money in circulation and is positive on the economy. However if the discount rate is higher than the federal funds rate banks will lend to other banks making no impact on the money supply.

The required reserve ratio is another tool the Federal Reserve uses to control the amount of money a bank is holding either in the depository or with the Federal Reserve. It is the percentage amount they require the bank to hold as a reserve. If the ratio is decreased banks are required to hold less in reserves in turn they can lend more to their customers increasing the money supply spent. But if the reverse occurs and the ratio drops, banks will be forced to draining themselves lending less and resulting in a decrease of money in circulation.

Open market operations are the mechanism most used by the Federal Reserve for controlling the money supply. The market is comprised of T-bills, bonds and all other Federal instruments that are bought and sold through investors. These transactions have a great impact on the economy sales from these can either drain the system or put an abundance of money back into the system. When the Federal Reserve purchases such securities it is increasing the amount of money in circulation for the amount of that purchase but also increases the amount of reserves in the banking system that are available for lending purposes. There three tools are the foundation our countries money supply, each of them makes an impact on the societies money circulation. I will continue to discuss the impact these three indicators have on gross domestic product, employment rates, inflation and interest rates.

To begin I will start by defining gross domestic product, unemployment, inflation and interest rates. Gross domestic product is the total market value of all final goods and services produced in one year (Brue, S. & McConnell, C., 2004). The gross domestic product is the primary measure of the economy's performance and its total output of goods and services or otherwise names the aggregate product. The gross domestic product includes all goods and services produced within the country whether they are citizen supplied or foreign supplied. By keeping track of the finished goods and services produced in the United States within a given year economists can measure the inputs and outputs effect on the national income. When counting gross domestic products it is important to note that the goods are only counted in the final production or manufacturing stage, this avoids products being counted twice. The gross domestic product is relatively accurate in measuring the state of the economy, however it does have several shortcomings such as not being able to measure any non-market activities, improving quality of production does not affect the overall outcome, and it does not account for the underground economy which is the population involved with a number of different businesses and conceal their incomes, they account for 8% of the population (Brue, S. & McConnell, C., 2004).

Measuring the employment rate is done by first determining by 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 (Brue, S. & McConnell, C., 2004). The labor force is made up of people who are willing and able to work. The calculation to determine the percentage of labor force unemployed is to take the unemployed divided by the labor force multiplied by 100 equals the unemployment rate. The unemployment rate has a large impact on the economy. The gross domestic product and Okun's law