Monetary Policy And The Federal Reserve

Maintaining price stability, full employment and economic growth are the goals of both fiscal policy and monetary policy. While fiscal policy consists of deliberate changes in government spending and tax collections, monetary policy addresses changes in the money supply to influence interest rates and the total level of spending in the economy (McConnell and Brue, 2004, p. 214, 268). There are pros and cons to each policy type, but overall, monetary policy can take effect in the U.S. economy faster. The Federal Reserve, consisting of 12 central banks, uses monetary policies in order to keep the national economies running as smoothly as possible. The Federal Reserve, or Fed, must use tools to control the money supply and thereby influence the economy. This paper will discuss the tools used by the Fed in monetary policy-making and how these tools influence money supply and macroeconomic factors. In addition, money creation will also be addressed, including how the creation of money might influence the monetary policies.

The money creation process, controlled by the Federal Reserve System, or Fed, is mainly meant to change the total quantity of money in circulation and implementing monetary policy.

Amosweb.com explains money creation as

“The process in which banks increase the amount of funds in checkable deposits (and thus the M1 money supply) by using reserves to make loans. Money creation is made possible through fractional-reserve banking. Because banks keep only a fraction of deposits as reserves, extra reserves can be used to back up and create additional checkable deposits (money) that did not previously exist. Government policy makers (the Federal Reserve System) rely on the money creation process when conducting monetary policy. Money creation by banks is a modern alternative to printing paper currency” (2008).

Through this process, banks are able to generate valuable money

McConnell and Brue (2004), state that there are three types of transaction in which money is created inside a commercial bank. When commercial banks grant loans, they are creating money. Conversely, money is reduced as bank loans are repaid. Also, banks generate new money when buying government bonds, or securities from the public. However, as McConnell and Brue further explain, as commercial banks sell securities to the general public, money disappears (p. 260).

The Federal Reserve, or Fed, uses three tools to control money supply: Open-market operations, the reserve ratio and the discount rate. Using these tools, the Fed influences the commercial banking system and its ability to create money. According to McConnell and Brue, “open-market operations are the Fed’s most important instrument for influencing the money supply” (2004, p. 270). Buying government bonds from and selling government bonds, or securities, to commercial banks and the general public comprises open-market operations. This tool, McConnell and Brue further explain, has flexibility, a key advantage. Securities can be bought and sold in large or small amounts, and the impact on bank reserves is prompt.

When manipulating the reserve ratio, the Fed influences the commercial banks’ ability to lend. When the Fed requires an increase in reserves, the banks must lose the ability to create money by lending. However, should the Fed lower the reserve ratio, required reserves would transform into excess reserves and enhance the ability of the banks to create money by lending. Changing the reserve ratio affects the banking system by changing the amount of excess reserves and changing the size of the money multiplier. Compared with open-market operations, McConnell and Brue explain, changing the reserve requirement is less important when exercising monetary control. Reserves earn no interest, and as a consequence, raising or lowering the reserve allowance has quite an effect on bank profits.

Finally, the discount rate is the interest rate charged when a commercial bank borrows money from a Federal Reserve Bank. Since the loans made by a Federal Reserve Bank to a commercial bank increase the commercial bank’s excess reserves, their ability to extend credit is enhanced, thereby creating more money, according to McConnell and Brue (2004). Essentially, the discount rate acts as a cost of acquiring resources. While the discount rate is lower, commercial banks may be encouraged to see more resources from the Fed. However, the Fed may increase the discount rate should they want to restrict the money supply. Only two to three percent of commercial bank reserves are acquired from the Federal Reserve Banks, according to McConnell and Brue (2004), and actually open-market operations often lead the commercial banks to borrow from the Federal Reserve Banks.

The tools of monetary policy affect macroeconomic factors such as unemployment rates, inflation and Gross Domestic Product (GDP). According to the Monetary Policy simulation (University of Phoenix, 2008), the Fed must make decisions regarding the use of each tool