Monetary Policy And Its Affect On Macroeconomic Factors

Abstract

This paper is a discussion of how a monetary policy effects specific macroeconomic factors as GDP, unemployment, interest rates and inflation. Included in the discussion is how different combinations of monetary policy tools are utilized to manage an economy.

Monetary Policy and Its Effect on Macroeconomic Factors

Monetary policy consists of deliberate changes in the money supply to influence interest rates and thus the level of spending in the economy. The goal of a monetary policy is to achieve and maintain price level stability, full employment and economic growth. (McConnell & Brue, 2004, p. 268, Ð'¶ 1)

A basic discussion on how commercial banks and the banking system create money is needed to understand how the Fed utilizes tools at its disposal to implement a monetary policy.

The United States has a fractional reserve banking system in which only a fraction of the money supply is held in reserve as currency. (McConnell & Brue, 2004, p252, Ð'¶ 5) Since the U.S. utilizes this type of system the Fed has placed restrictions on commercial banks to ensure that proper banking practices are followed, among the restrictions is a reserve ratio requirement. A Reserve is a requirement that all commercial banks must maintain cash on hand to equal a predetermined percent of the checkable deposits liabilities that a bank currently holds or a reserve ratio. Therefore a bank can lend only an amount equal to its excess reserves. For example, if a bank has $100 in checkable deposits and the reserve ratio is 10% then the bank must hold back $10 as a reserve, that is the bank can only loan out $90 not the full $100. The primary purpose of the reserve ratio is to control a banks ability to lend and prevent the bank from overextending credit or under extending credit. (McConnell & Brue, 2004, p.256, Ð'¶ 3)

A bank creates money through the creation of loans. That is a bank takes a promissory note, an IOU, in exchange for an interest earning line of credit and thus increases John Doe’s or Company XYZ’s checkable deposit with the bank. (McConnell & Brue, 2004, p. 258, Ð'¶ 7) Remember that a bank can only loan an amount equal to its excess reserves, therefore, if Bank A has $100 in checkable deposits on hand the bank is then able to loan out or create up to $90.

When a bank creates a loan (money) the total money supply increases by the loan amount. But in the bigger picture that initial $90 loan has the potential to increase the money supply or create an additional $900. (McConnell and Brue, 2004, p 262) This increase in the money supply is the result of multiple deposit expansion. For example when the $90 loaned by Bank A is taken out of Bank A and deposited into Bank B, the $90 deposited into Bank B is now available for lending, minus the reserve ratio, in our example 10%. Therefore, Bank B can then loan out $81. The cycle will continue until the original amount is fully loaned out. The reserve ratio set by the Fed controls the amount of money that can be created. The higher the ratio the lower the expansion and the lower the ratio the higher the expansion. (McConnell and Brue, 2004, p. 262)

Money is also created by commercial banks through the buying of government securities or bonds. This type of transaction is basically the same as lending and from the earlier discussion money is created. “The bank accepts government bonds (which are not money) and gives the securities dealer an increase in its checkable deposits (which are money)”. (McConnell and Brue, 2004, p. 259, Ð'¶ 11)

Since a monetary policy is used to effect the supply of money, the policy will effect various factors of a macroeconomic environment, GDP, Unemployment, Inflation and Interest Rates. The factor most directly effected by the supply of money is the interest rate or the cost of money. The greater the supply of money, the lower the interest rates and inversely the smaller the supply of money, the higher the interest rates.

The cost of money also effects the other factors in the macroeconomic environment.

Simply, the higher the cost of money the lower the spending and the lower the cost of money the higher the spending. The levels of spending also effect the GDP. The lower the spending the lower the demand for goods and services the GDP decreases, effect the GDP. When spending is increased the inverse occurs, the higher the demand for goods and services the GDP increases.

When total spending rises typically cyclical unemployment will decrease or stay consistent, when spending falls cyclical unemployment will tend to rise. Excess spending from an over supply of money will cause price levels to rise. Spending also effects demand-pull inflation as demand rises for goods and services so to do the prices for those goods and services or demand-pull.

“The Fed has three tools of monetary control it can use to alter the reserves