Monetary Policy

Macroeconomics Research Paper

Written by: Luis Tobar

Professor Tvelia

Monetary policy is defined as the process by which the government, central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets Economics primarily focuses on how laws and government policies impact the economy. Much of this looks at taxes specifically and more generally the public finance, which includes the spending and borrowing the government does. Economy can be described as the current soundness of financial indicators such as jobs and job growth, economic productivity and output, and can also be measured by a vast range of other factors such as the trade deficit, national debt, GDP, and unemployment rates. In this paper, the effects of the monetary policy on macroeconomics, inflation, unemployment, Gross Domestic Product (GDP) and interest rates will be discussed. Throughout the paper explanations of how money is created will be given along with discussing what monetary policies combination will achieve the goal of economic growth, low inflation, and a reasonable rate of unemployment, what combination of monetary policies will better accomplish this goal.

One goal of the Federal Reserve, commonly known as the Fed, is to affect the economic production and employment, both of which depend on many other factors. They are influenced by monetary policy; when demand weakens, the fed lowers interest rates, which in turn stimulates the economy, by allowing the consumer to spend more and the industry to produce thus job retention is good. In contrast, continuous stimulus to increase salary or if demands falls, productivity will decrease, jobs are lost and this will push the economy's inflation higher. The Fed just tries to smooth out the bumps of natural business cycle. Inflation is an economy wide rise in prices which is bad because it makes it hard to tell if a business product price is going up because of higher demand or inflation. Inflation also adds premium to long-term interest rates. Much debate encircles whether zero inflation is a target. Some economist says that when inflation is low, interest rates are low so the fed does not have much room to boost the economy if it is necessary. When inflation is close to zero there is more risk of deflation. Deflation occurs when there is a nation wide fall in prices. On the surface, this may sound optimal for the consumer but this is just as bad as inflation. A prolonged deflation, like the great depression, can lead to significant declines in home and business values. With low prices come low interest rates, and less room for the fed to stimulate the economy. The main goal is to keep the economy steady, achieve neutrality. An utopian economical society looking for the perfect blend of policies to create a solid economy.

The feds influence the market mainly by raising or lowering interest rate called the "federal funds". Banks are required to keep a certain amount of money in reserves to pay for overnight checks, stock ATMs, and other payments. When a bank is running low on reserves it may borrow some from a bank with too many reserves. The interest rates on these loans adjust to supply and demand. If the fed wants to raise or lower the rates, it buys or sells securities from banks, in which the bank receives or sells in reserves. They do this until the banks have too many reserves and must loan them out, so the interest rate lowers, or the banks do not have enough reserves and must borrow, causing interest rates to rise. The fed also pays attention to foreign markets. When the dollar is too low, the feds buy out dollars (with foreign currency) to cushion the pressure.

How is money created?

Most money does not exist in tangible form. In fact, less than 10%t of U.S. money is in the form of bills or coins. Over 90% exists only as electronic data stored in a computer. For example, Mr. X has some money. Although he may have some cash, most of his money exists in bank accounts or brokerage accounts, and his wealth is stored as data in various computer systems.

There are two ways in which new money can be created. First, it can be printed as bills or manufactured as coins. More frequently, however; money is created just by changing the data stored in a computer. For instance, if his bank was to credit his checking account with, say, a million dollars, all that would happen is that they would make a new entry in their computer. As soon as they made this entry, he would have a million dollars to his name. No new bills or coins would need to be created. (Colander, 2004)

Although it is unlikely that Mr. X's bank is going to credit his account with a million dollars out of the goodness of their heart, the scenario described is similar to the way in which most of the money in the economy is actually created. When money is put in the bank, the bank does not keep all the money in a vault (or even in a computer). They loan most of it out to other people. That is how banks make a profit: they accept a deposit from one person, and loan the money to another person. The profit comes from loaning the money out at a higher rate of interest than what they pay for it. For example, a bank might pay Mr. X 4% interest on his savings account, but loan the same money out to another customer at 12% interest, 18% interest if the credit is less than favorable.

The Federal Reserve, which regulates banking, does not let banks loan out all their deposits. By law, banks must retain a certain amount of money on reserve, called the reserve rate. In most cases, the reserve rate is 10%. In other words, banks are allowed to loan out 90% of the money that they accept for deposit.