Monetary Policy

Monetary Policy and the Effect on Macroeconomic Factors

"Simplistically, it looks like the Fed tries to use money supply as a lever to keep the economy on the rail." Monetary Policy Simulation University of Phoenix, 2007.

Yet monetary policy is only effective with the creation of money. Banks create money through lending. An early "embryonic banker" (McConnell & Brue, 2004, P253), the goldsmith, was the impetus for the creation of the first reserve system which initiated the creation of paper money. The goldsmith had to denote the amount of reserve essential for insurance before generating the paper money. As the newly created reserve system grew, the natural tendency to bank panics led to the need for regulations. The banking systems' ability to create money rests on the assumption that commercial banks are willing to create money by lending and that households and businesses are willing to borrow. The process is cyclical and creates the need for some kind of control.

Monetary policy is made by the Federal Open Market Committee, which consists of the Board of Governors of the Federal Reserve System and the Reserve Bank presidents. The ultimate goal is maintain price-level stability, full employment, and economic growth. (McConnell & Brue, 2004, P268). The Federal Reserve, also known as the Central back of the United States, has the primary responsibility of the formulation of monetary policy. This responsibility is carried out by setting the Federal Reserve Rate and the Discount Rate as well as the influential operations of Open Market Operations.

Open market operations are the Federal Reserve's principal tool for implementing monetary policy. In the New York Fed's Guide to understanding the workings of the Fed, it states "The Federal Open Market Committee (FOMC) directs the primary and, by far, the most flexible and actively used instrument of monetary policy--open market

operations--to effect changes in reserves."

When Federal Reserve Banks buy securities on the open market, commercial banks' reserves are increased which then increases the lending ability of the commercial banks. (McConnell & Brue, 2004, P270). Also, when the Fed sells government bonds, the additional supply of bonds on the bond market lowers bond prices and raises their interest rates, making government bonds attractive purchases for banks and the public. (McConnell & Brue, 2004, P273).

The Reserve Ratio is another technique for the Fed to affect the monetary policy in the United States. The ratio ultimately influences the lending ability of the commercial banks. The Fed has the power to raise the reserve rate which diminishes the loan pool and lowers the reserve ratio which enhances the commercial bank's ability to create additional money through lending opportunities. The reserve ratio controls both the amount of excess reserves held at the Federal Reserve Bank and changes the money multiplier.

"One of the functions of the central bank is to be a 'lender of last resort'" (McConnell & Brue, 2004, P274). The Federal Reserve has the power to lend short term money to commercial banks with a promissory note to bide them over until sufficient funds are available. The actual rate that the Federal Reserve Bank charges it called the discount rate. The loan is used to increase the reserve and allow additional credit to their customers.

If a recession occurs, the Fed must increase the money supply to stimulate the economy. The stimulation is provided through the purchase of securities which increase commercial bank reserves, the discounting of the reserve ratio allows more loanable money, and the lowering of the discount rate so the banks can borrow more reserves from the Fed.

If the economy is forced into an inflationary era, securities should be sold to reduce the commercial bank reserves, the reserve ratio should be increased which will slow the amount of loans, and the discount rate should be raised in order to increase the reserves. The Fed must affect demand across the economy and increase the willingness for the consumers to spend their money on additional goods and services. The Fed must also consider other factors influencing the public's buying decisions including technology and people's individual preferences for saving, risk, and work effort.

Through the Full Employment and Balanced Growth Act, Humphrey-Hawkins Act of 1978, amended The Monetary Policy and Unemployment Under the Federal Reserve Act, the Federal Reserve and the FOMC are charged with the job of seeking "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." The Fed must keep the unemployment levels in check by working towards the all workers employed and all jobs filled.

As inflation begins to arise and every dollar will buy a smaller percentage of a good, the government can adjust the economy. The Federal Reserve can sell bonds, increase the reserve ratio and increase the discount ratio to stimulate the economy. Once initiated the excess reserves will decrease, the interest rate will rise, the investment spending will decrease, the aggregate demand will decrease and the finally the overall inflation rate will decline. Although it is imperative that the Fed accounts for operational lag in the changes. Also important to acknowledge is the velocity of money and the amount of time per year an average dollar is spent in the market. Monetary Policy can work both ways in the economy through expansion and contrationary policies, but a cyclical asymmetry may occur as the cycle completes.

Still the economy goes through business cycles in which output and employment are above or below their long-run levels. Even though monetary policy cannot affect either output or employment in the long run, it can affect them in the short run. For example, when demand weakens and there's a recession, the Fed can stimulate the economy, temporarily, and help push it back toward its long-run level of output by lowering interest rates. That's why stabilizing the economy by smoothing out the peaks and valleys in output and employment around their long-run growth paths is a key short-run objective for the Fed and many other central banks. http://www.frbsf.org/publications/federalreserve/monetary/index.html

Changes