Monetary Policy

Monetary Policy in the United States

Abstract

The role of government in the American economy goes past just being a regulator for specific industries. There are two main tools for achieving these objectives: fiscal policy and monetary policy. The Federal Reserve sets the nation's monetary policy to promote the objectives of maximum employment, stable prices, and moderate long-term interest rates.

Monetary Policy in the United States

Monetary policy is the government or central bank process of managing money supply to achieve specific goals (wikipedia.org). The United States monetary policy affects all kinds of economic and financial decisions people make in this country. Whether to buy a car, or build a house, start a new company, or invest. The United States is the largest economy in the world, significantly affecting the economic and financial effects on other countries.

In 1694, the Bank of England was created requiring the ability to print paper money or notes and back them with gold (federalreserve.gov). The goal of the monetary policy was to maintain the value of the print notes. The industrialize nations set up central banking systems between 1870 and 1920. The Congress established the Federal Reserve System in 1913 to strengthen the supervision of the banking system and stop bank panics that had erupted periodically in the previous century. They were one of the last systems set up. At this time, it was clear that there was a business cycle, and economic theory began to understand the relationship of the interest rate to that cycle. Because of the Great Depression in the 1930s, Congress gave the Federal Reserve authority to vary reserve requirements and to regulate stock market margins. In the late nineteenth century, monetary policy was used to maintain the gold standard.

During much of the 1970s, the Fed allowed rapid credit expansion in keeping with the government's desire to combat unemployment. Monetary policy objective is to influence the performance of the economy, in inflation, exchange rate with other currencies and unemployment. Monetary authority has the ability to alter the interest rate and the money supply, with affecting the demand of the economy. The Federal Reserve System influences demand mainly by altering the (raising and lowering) short-term interest rates, to achieve policy goals. These goals are listed in the 1977 amendment to the Federal Reserve Act. With inflation increasingly devastating the economy, the central bank abruptly tightened monetary policy beginning in 1979. This policy successfully slowed the growth of the money supply, but it helped trigger sharp recessions in 1980 and 1981-1982. The inflation rate did come down, however, and by the middle of the decade the Federal Reserve was again able to pursue a cautiously expansionary policy. Interest rates, however, stayed relatively high, as the federal government had to borrow heavily to finance its budget deficit. Rates slowly came down, too, as the deficit narrowed and ultimately disappeared in the 1990s.

The growing importance of monetary policy and the diminishing role played by fiscal policy in economic stabilization efforts may reflect both political and economic realities. Fighting inflation requires government to take unpopular actions like reducing spending or raising taxes, while traditional fiscal policy solutions to fighting unemployment tend to be more popular since they require increasing spending or cutting taxes. Political realities, in short, may favor a bigger role for monetary policy during times of inflation.

The first goal of Monetary Policy is for maximum output. The economy goes through business cycles, which will affect the output and employment in the short run. When demand is in power than there is a recession, in which the Federal Reserve can stimulate the economy on a short-term bases. They do this by lower the interest rates. However, they are unable to stimulate the economy on a long-term basis. IF they did so, the inflation would sky rocket and unemployment would not stabilize. A higher inflation can encumber economic growth. When inflation is high people start become scared and about the future.

The second goal of monetary policy is to stabilize the prices for the long run. This is known as low inflation. People start investing, buying homes, and starting new businesses. Even though low inflation is achievable in the end, it is not the focus, because in the end it becomes costly to all.

The Federal Reserve has three main tools for maintaining control over the supply of money and credit in the economy. The most important is open market operations, or the buying and selling of government securities. To increase the supply of money, the Federal Reserve buys government securities from banks, other businesses, or individuals, paying for them with a check (a new source of money that it prints); when the Federal Reserves' checks are deposited in banks, they create new reserves. (www.frbsf.org). The bank then can lend the excess reserves to other banks in the federal market or invest, thereby increasing the amount of money in circulation. If the Federal Reserve wants to reduce the money supply, it sells government securities to banks, collecting reserves from them. Because they have lower reserves, banks must reduce their lending, and the money supply drops accordingly. The Federal Reserve cannot control output an input directly, so it tries to do it indirectly. They do this may lowering short-term interest rates.

The Federal Reserve also can control the money supply by specifying what reserves deposit-taking institutions must set aside either as currency in their vaults or as deposits at their regional Reserve Banks. Raising reserve requirements forces banks to withhold a larger portion of their funds, thereby reducing the money supply, while lowering requirements works the opposite way to increase the money supply. Banks often lend each other money over night to meet their reserve requirements. The rate on such loans, known as the "federal funds rate,"