Monetary Policy

The Fed another name for the Federal Reserve Bank that makes the central bank in the United States has three tools of monetary policy they can use to control the money supply. They are open-market operations, the reserve ratio, and the discount rate. These three tools used by the Fed influence the money supply have an impact on gross domestic, product (GDP), inflation, and unemployment. The Fed's open-market operations consist of the buying of government bonds from, or the selling of government bonds to, commercial banks and the public. Open-market operations are the Fed's most important instrument for influencing the money supply (p.270). When the Fed decides to buy government bonds from commercial bank or/and the general public the reserve of the commercial banks increase and when they decide to sell the same bond, commercial banks' reserve are reduce. Buying bonds increases the reserves banks will hold, this enables banks to lend more money and they can reduce interest rates. While lower interest rates are available, consumers will be more willing to borrow money to make larger purchases. The Reserve Ratio is another tool that the Fed uses to control the money supply. The reserve ratio is a percentage of deposits that a bank holds as reserves. The Fed mandates a certain percentage of this ratio for commercials banks to hold in their reserves. Raising the reserve ratio can lead to a decrease in excess reserves and prevent lending abilities by commercial banks. If the Fed lowers the reserve ratio the opposite will occur, excess reserves will increase and commercial banks will be able to create money for lending. The Discount Rate is the interest rate that the Fed charges commercial banks for loans. Banks are able to borrow from the Fed if the discount rate charged by the Fed is lower than the federal funds rate charged by other banks. As the discount rate is decreased, banks shift their source of borrowing from other banks to the Fed. As they do so, the total amount of money in the system is increased. If the spread is positive, banks will always borrow from other banks, this will have no effect on the money supply.

When the economy is facing recession or high unemployment the Fed must buy government bonds, lower the reserve ratio, or lower the discount rate. Excess reserves will increase causing the money supply to rise. Interest rates will fall causing investment spending to increase. The aggregate demand will increase causing real GDP to rise by a multiple of the increase in investment. These actions are called an easy money policy (McConnell & Brue, 2004, p. 275). When the economy is facing inflationary period the Fed must do the opposite of an easy money policy. The Fed must sell government bonds, increase reserve ratio, or increase the discount rate. Excess reserves will decrease causing the money supply to fall. Interest rates will increase causing investment spending to decrease. Aggregate demand will decrease causing inflation to decline. These actions are called a tight money policy (McConnell & Brue, 2004, p. 275). Buying government bonds will release money into the system causing an increase in Real GDP. The increase to Real GDP will cause unemployment to decrease because work production will start rising due to investments and consumer demand. Investment will increase due to interest rate being low. The downside effect to releasing money into the system is an increase of inflation. Selling government bonds causes the opposite effect on Real GDP, unemployment, interest rates, and inflation. Selling government bonds takes money out of the system; therefore, Real GDP, interest rate and inflation will decrease while unemployment starts to increase.

Money can be created by commercial banks. The commercial banks primary way of creating money is through lending. When commercial banks receive checkable deposits from the public, money is not created; however, the composition obtained by the bank has increased. By law, all commercial banks must provide a certain percentage of checkable deposits in required reserves. Required reserves are a number of funds to specified percentage of the bank's own deposit liabilities (McConnell