Monetary Policy

Monetary Policy

Introduction

“The goals of monetary policy include the promotion of sustainable economic growth, full employment, and stable prices. Through monetary policy, the Fed is most able to maintain stable prices, thereby promoting economic growth and maximum employment,” (Fed101, n.d.). An understanding of macroeconomic policy changes and the impacts will help producers of products anticipate the consequences of alternative policies and take appropriate actions. These actions shall be in business decisions and as participants in the public policy making process. The goal is for the Federal Reserve to know when to use the tools to control the money supply.

Tools Used by the Federal Reserve

The Federal Reserve has three tools used in monetary policy and those tools are open-market operations, the reserve ratio, and the discount rate. The Monetary Policy simulation addresses the spread between the Discount Rate (DR) and the Federal Funds Rate (FFR), Required Reserve Ratio, and Open Market Operations. The Monetary Policy simulation shows how the changes in the Discount Rate, Federal Funds Rate, Required Reserve Ratio, and Open Market Operations affect the Real GDP (Gross Domestic Product), 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 general public,” (McConnell & Brue, 2004, p. 270). The open-market operations tool is most important to the fed’s for influencing the money supply. The open-market operation tool is the most frequently used due to the flexibility of the open-market operations. “The term вЂ?open market’ means that the Fed doesn’t decide on its own which securities dealers it will do business with on a particular day. Rather, the choice emerges from an вЂ?open market’ in which the various securities dealers that the Fed does business with-the primary dealers-compete on the basis of price,” (Fed101, n.d.). During the buying of securities the reserves of the commercial banks increases. The increase comes from the Federal Reserve Banks buying government bonds from commercial banks or from the public. When the Federal Reserve Banks buy government bonds from the commercial banks the most important factor in this transaction is the increase to lending ability of the commercial banks. When the Federal Reserve Banks buy government bonds from the public the outcome is the same and the outcome when buying from the commercial banks. The slight difference between the Federal Reserve Banks purchasing government bonds from the instead of the commercial banks is, “public increase actual reserves but also increase checkable deposits when the sellers place the Fed’s check into their personal checking accounts,” (McConnell & Brue, 2004, p. 271). The commercial banks’ reserves are increased if the Federal Reserve Banks buy government bonds from the commercial banks or the public so in the open-market operations buying from either commercial banks or the public will achieve the same result. In retrospect when the Federal Reserve Banks sell securities to the public or commercial banks the Federal Reserve Banks reserves are reduced.

The second tool used by the Federal Reserve is the reserve ratio and the management of the reserve ratio can influence the ability of the commercial banks to lend. “Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities,” (The Federal Reserve Board, n.d.). The Board of Governors has sole responsibility in changes made to the reserve requirements. The feds have could increase or decrease the reserve ratio. “A decrease in the ratio will allow the bank to lend more, thereby increasing the supply of money,” (Cloutier, n.d.). By decreasing the reserve ratio the banks are able to create new money through lending. An increase in the reserve ratio increases the amount of reserves banks are required to keep. “The last such change was in 1992, when the Fed lowered the reserve ratio from 12 percent to 10 percent,” (McConnell & Brue, 2004, p. 274). The New York Times Business section reports in 1992, “In an unusual move aimed at increasing bank lending to spur the economy, the Federal Reserve announced today that it was cutting the amount of money that banks must hold in reserve to offset possible losses,” (Greenhouse, 1992). This change in monetary policy was to encourage banks and lenders to give more credit thereby decreasing the amount of reserves banks are required to keep. The reserve ratio tool is rarely used and could be powerful especially when trying to ward off recession. Greenhouse reported in 1992 that “Economists said it would be difficult to estimate whether today's move would have as great an effect on spurring the economy as even a small cut in the discount rate,” (Greenhouse, 1992).

The lender of last resort is referred to as the discount rate and the third tool used by the Federal Reserve. “Just as commercial banks charge interest on their loans, so too Federal Reserve Banks charge interest on loans they grant to commercial banks. The interest rate they charge is called the discount rate,” (McConnell & Brue, 2004, p. 274). Loans to commercial banks from the Federal Reserve Banks appear as an asset on the balance sheet of the Federal Reserve Banks but as a promissory note or IOU and a liability to the commercial bank’s balance sheet. McConnell and Brue state, “borrowing from the Federal Reserve Banks by commercial banks increases the reserves of the commercial