Macroeconomic Impact

Macroeconomic Impact

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

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).

Federal Reserve

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. And lastly, if the Fed chases only price stability, the price level is not free to increase (Thorbecke, 2002, pp. 255-256).

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