Macroeconomic Impact Of The Federal Reserve Bank

Running Head: Macro Impact of The Federal Reserve Bank

Macro Impact of The Federal Reserve Bank

The University of Phoenix

Abstract

The federal government has empowered its central bank, The Federal Reserve, with the ability to influence the amount of money available to the U. S. economy as a means to regulate unemployment, inflation, interest rates and gross domestic product.

Macro Impact of The Federal Reserve Bank

Monetary policy can influence the economy and provide much needed assistance to improve a declining economy or reduce possible inflation increases in an over stimulated economy. The Federal Reserve has the ability to make money and to reduce the amount of money in circulation. When the Federal Reserve decides that it needs to assist declining economy or rapidly rising interest rates, the Federal Reserve has three tools for controlling the supply of money at its disposal.

First, the Federal Reserve can buy or sell securities. If the situation dictates that the money supply needs to be increased, the Federal Reserve will purchase government bonds from commercial banks or the public. By doing so, the Federal Reserve increases the money available either by increasing banks lending power or increasing the amount of money to the public entity that owned the security (McConnell-Brue, 2004, p. 270). The Federal Reserve purchases bonds from commercial banks, those banks give up part of their securities holdings in exchange for the Federal Reserve paying for the securities. The payment increases the reserves of the commercial banks by the amount of the purchase. The results of purchasing from the public are similar; the Federal Reserve pays a particular person or entity for a portion of its holdings with a Federal Reserve check. The entity deposits the check into its commercial bank. The commercial bank then sends that amount to the Federal Reserve to increase its reserves (McConnell-Brue, 2004, p. 270). The result is the same whether the Federal Reserve buys from the public or commercial banks: commercial banks have more on reserve with the Federal Reserve, thus are able to lend more thus more money is available for circulation. If Federal Reserve determines that it should decrease the amount of money in circulation, the Federal Reserve will sell securities to commercial banks or the public. The money exchange works opposite from buying securities. The public or commercial banks will purchase the securities and decrease the amount of money a commercial bank can lend through decreasing the banks reserves held by the Federal Reserve (McConnell-Brue, 2004, p. 271-272).

A second tool available to the Federal Reserve Bank is the ability to set the reserve ratio. The reserve ratio is the percentage of funds that each commercial bank must deposit with the Federal Reserve based on the commercial banks deposits and plans for future lending (McConnell-Brue, 2004, p. 254). By increasing the reserve ration, the Federal Reserve will shrink the amount of money available for a bank to lend. Commercial banks have two options available when the Federal Reserve raises the reserve ratio; either deposit more money into the Federal Reserve Bank or decrease the amount of loans granted. Either choice decreases the amount of money available to lend. Conversely, the Federal Reserve can increase the amount available for a commercial bank to lend by reducing the reserve ratio (McConnell-Brue, 2004, p. 273-274).

The final tool available is the Federal Reserves control over the discount rate. Commercial banks will borrow from the Federal Reserve and the interest rate charged on these loans is called the discount rate (McConnell-Brue, 2004, p. 274). By lowering the discount rate the Federal Reserve entices commercial banks to borrow more which will increase the amount those banks have available to lend. The Federal Reserve can decrease the money supply by increasing the rate. Commercial banks are discouraged from borrowing from the Federal Reserve and have less money to lend (McConnell-Brue, 2004, p. 275).

Through any combination of these tools, the Federal Reserve can influence the GDP, unemployment, inflation and interest rates. When the Federal Reserve buys securities, lowers the reserve ratio and or lowers the discount rate, the reserves available to the commercial banks increases (McConnell-Brue, 2004, p. 278). The intention of increasing commercial bank reserves is to increase money supply. The law of supply and demand dictates that when money supply is increased, the interest rate decreases. This result is not guaranteed, but is the hope of the Federal Reserve Bank. The interest rate can be thought of as the value of the money. As money increases, its supply curve will shift left and the equilibrium point between interest rate and money will be repositioned at a point with more money and lower rates (McConnell-Brue, 2004, p. 276). The opposite is also true; if the Federal Reserve sells securities, raises the reserve ratio and or raises the discount rate, they are actually reducing the amount of money which will shift the money supply curve to the right, decreasing the supply of money and increasing the interest rate of money.

The choice to increase money also includes the goal of reducing unemployment and promoting economic growth. Economists historically, have assigned the Federal Reserve’s choice to increase money as a main contributor in keeping unemployment rates down (McConnell-Brue, 2004, p. 281). The Federal Reserve’s decision to keep money easily supplied to commercial banks helped the United States recover from recession in the early 1990’s (McConnell-Brue, 2004, p. 281). When the money supply is increased, banks are able to lend more money, interest rates remain low and consumers have more buying power. Increased buying power leads to increased spending which stimulates economic growth. Growing economies have a higher demand for labor to keep up with demand for goods and services. Thus unemployment rates remain low.

Gross domestic product is affected by the interest rate and the amount of money available (McConnell-Brue, 2004, p. 278). According to McConnell-Brue (2004), investment spending is on of the “determinants of aggregate demand” which will mean that the greater the investment spending, the higher the demand for money (278). Conversely, the more money available to investors should lead to increased investment. Increased investing should increase the demand for money which should