Monetary Policy And Its Effects

Running head: Monetary Policy and Its Effects

Monetary Policy and Its Effects

University of Phoenix

October 27, 2007

Monetary policy has two basic goals: to promote "maximum" sustainable output and employment and to promote "stable" prices. These goals are prescribed in a 1977 amendment to the Federal Reserve Act. (Federal Reserve Bank of San Francisco, 2007)

The Federal government uses various tools to control money. The Federal Reserve cannot control inflation or influence output and employment directly; instead it affects them indirectly, mainly by raising or lowering a short-term interest rate called the "federal funds" rate. Most often, it does this through open market operations in the market for bank reserves, known as the federal funds market. Banks and other depository institutions keep a certain amount of funds in reserve to meet unexpected outflows. Banks can keep these reserves as cash in their vaults or as deposits with the Federal Reserve. In fact, banks are required to hold a certain amount in reserves. But typically, they hold even more than they are required to in order to clear overnight checks, restock ATMs, and make other payments. (FRBSF, 2007)

The point of implementing policy through raising or lowering interest rates is to affect people's and firms' demand for goods and services. Policy actions affect real interest rates, which in turn affect demand and ultimately output, employment, and inflation. The Federal Reserve operates only in the market for bank reserves. Because they are the sole supplier of reserves, the Federal Reserve can set the nominal funds rate. The Federal Reserve cannot set real interest rates directly because it cannot set inflation expectations directly, even though expected inflation is closely tied to what the Federal Reserve is expected to do. In general, the Federal Reserve has stayed out of the business of setting nominal rates for longer-term instruments and instead allows financial markets to determine longer-term interest rates. (FRBSF, 2007)

Long-term interest rates reflect, in part, what people in financial markets expect the Federal Reserve to do. For instance, if they think the Federal Reserve is not focused on containing inflation, they will be concerned that inflation might move up over the next few years. So they will add a risk premium to long-term rates, which will make them higher. In other words, the markets' expectations about monetary policy tomorrow have a substantial impact on long-term interest rates today. Researchers have pointed out that the Federal Reserve could inform markets about future values of the funds rate in a number of ways. For example, the Federal Reserve could follow a policy of moving gradually once it starts changing interest rates. The Federal Reserve could issue statements about what kinds of developments the Foreign Open Market Committee is likely to focus on in the foreseeable future; the Federal Reserve even could make more explicit statements about the future stance of policy. (FRBSF, 2007)

Money evolved from barter, and the limits of barter. In barter, two traders trade equal value of their services or commodities. Two major limitations in barter; First, the two traders must have and want to trade products or services of equal value. Second, as society grows and becomes anonymous, they must both be ready to make the trade at the same time, as the trust of the small group no longer exists. Currency and money developed to deal with these two limitations. Currency came into use first. It was a simple extension of barter. A commodity was chosen that could be divided into pieces and held for trading at a later date. Gold and silver have more recently been the favorite choices for currency early, livestock, grain, pieces of fired clay, beads, and even humans were used. All these commodities proved difficult to store and carry. Many deteriorated over time. Even gold and silver proved to be bulky to carry for larger transactions. Another major limitation of currency was its limited supply. As trading occurred in a growing economy, there was no convenient way to increase or decrease the supply of currency. (Krumm, 1997)

Modern money developed from the trade of goldsmithing at the end of the middle ages. At that time people began storing their excess gold and silver with the local goldsmith for safekeeping. When gold or silver was put in storage, a receipt was issued by the goldsmith to the owner, as a record of ownership. The paper receipts were much easier to carry than the gold or silver, especially for larger transactions, so they began to be used instead of the precious metal itself. (Krumm, 1997)

The enterprising goldsmiths figured out that they could loan out the gold they held for their customers, to third parties. Or better yet they could issue receipts instead of loaning the gold. The next step was recognizing that they could print more receipts and make even more loans than they held in gold. In the idea of loaning the value of gold they did not own, but only held in trust, and the value of gold that did not even exist, was the germ of the invention of modern money. As long as not everyone wanted to redeem his or her receipts and loans for gold at one time, this system created by the goldsmith/bankers did facilitate trade when there was a shortage of the commodity, gold, which was used as currency. The fact