Monetary Policy

United States' monetary policy affects many economic and financial decisions people make in this country. For example, whether to get a loan to buy a new house or car to start up a company, and whether to put savings in a bank, in bonds, or in the stock market. Since the United States is the primary economy in the world, its monetary policy also has major economic and financial effects on other countries. The purpose of monetary policy is to manipulate the performance of the economy in such factors as inflation, economic output, and employment. It works by affecting demand across the economy, meaning people and firms' willingness to spend on goods and services. Furthermore, the Federal Reserve System, which is the nation's central bank, conducts monetary policy, it influences demand mainly by raising and lowering short-term interest rates.

While most people are familiar with the fiscal policy tools that affect demand, such as taxes and government spending, many are less familiar with monetary policy and its tools. In this paper, I will discuss monetary policy and its effect on macroeconomic factors such as Gross Domestic Product (GDP), unemployment, inflation and interest rate.

Commercial banks create money, or checkable-deposits, when they make loans. This is the most important source of money in the United States economy (McConnell-Brue, 2004, p 252). The process of a commercial bank can be understood through its balance sheet, or its statement of assets, and claims on assets, that sum up the financial situation of the bank. The balance sheet is where assets equal liabilities plus net worth. The value of assets must equal the amount of claims against those assets. In addition, commercial banks are required to keep reserves on deposit in a Federal Reserve Bank or as vault cash (McConnell-Brue, 2004, p 253). The reserves are the amount of funds equal to a specified percentage of the bank's own checkable-deposit liabilities as cash. Excess reserves are equal to the actual reserve minus the required reserves. This gives the Fed control over the lending ability to prevent overextending or under extending bank credit (McConnell-Brue, 2004, p 256). Furthermore, for a commercial bank to create money through lending depends on the amount of excess reserves. Meaning, they can only loan what they have in excess reserve. This is because the commercial bank faces a possibility of checks for the loan amount will be drawn and cleared against it, causing a loss in reserves. "Much of the money we use in our economy is created through the extension of credit by commercial banks" (McConnell-Brue, 2004, p258). By lending, the commercial bank acquires interest-earning asset and creates a checkable deposit or Ð''money' to pay for the asset. In addition, the commercial banking system can lend by a multiple of its excess reserve because the system cannot lose its reserves. This is based on each dollar of excess reserve. However, when loans are repaid money is destroyed. To create new money commercial banks will purchase government bonds from the public. Theses bonds earn interest creating an increase in the checkable deposit account (McConnell-Brue, 2004 p 259). The selling of these bonds will decrease the money supply. To sustain the goals of profitability and liquidity, banks will lend temporary excess reserves held at the Federal Reserve Bank to other commercial banks.

Furthermore, according to the Board of Governors Federal Reserve System (2008), money comes into transmission through the operations of the Federal Reserve Bank, which has the power to generate money. The Fed does this by a process of buying interest-bearing debt that was previously issued by the Treasury Department. For example, the Board of Governors Federal Reserve System (2008) states the Treasury issues a bond for $1000 in order to fund its spending needs if tax revenues are not sufficient. The bond pays an interest to its holder at maturity. The Fed can buy the bond with a check for $1000 written in a checkbook that has been given by Congress. The Fed simply has the authority to buy these government bonds from banks that hold them as reserves in their vaults, paying them with imaginary funds (McConnell-Brue, 2004, p 270). The Fed then gives the bank the right to note in its balance sheet that it has received $1000 from the Fed. When the Fed creates this money, it has converted interest-bearing debt to liquidity. This process, open-market operation, works because the public needs cash as a medium of exchange, and is agreeable to hold government debt for this purpose without being compensated by the payment of interest (McConnell-Brue, 2004, p 270). At the conclusion of a purchase, the Federal Reserve has in its balance sheet an asset of $1000 that is paying interest and a liability of $1000 that is not. The interest amount covers the expenses of managing the central bank, and surplus funds are given to the Treasury as part of its general revenues (Board of Governors Federal Reserve System, 2008). The Fed also has the authority to reverse this process. It can decide to withdraw liquidity from circulation, doing so by taking the $1000 bond from its portfolio of assets and selling it on the open market, to banks that are members of the Federal Reserve System (McConnell-Brue, 2004, p 273). The fact that the money supply can be altered in a pro-cyclical direction creates the need for the Federal Reserve System to use monetary tools to control the money supply in a countercyclical direction (McConnell-Brue, 2004, p 264).

The amount of money in circulation may affect economic outcomes. Therefore, the policy arsenal must contain some levers to control the money supply. "Monetary policy refers to the use of money and interest rates to alter economic outcomes" (Schiller, 2004, p 268). The tools of monetary policy include open-market operations, discount-rate change, and reserve requirements. The Federal Reserve uses these tools to change the money supply and shift the aggregate demand curve in the right direction. The objective of the monetary policy is to achieve full employment, price-level stability, and economic growth (McConnell-Brue, 2004, p 268). The Fed 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 (Walsh, 1994, p 1).

Every day, the amount of reserves a bank wants to hold may change as its deposits and transactions change. When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need. These loans take place in a private financial market, the federal funds market.