Monetary Policy

Monetary Policy

In the United States there are two different ways in which money can be controlled. The first way is through the Monetary Policy. Monetary policy is used to fight inflation or in other, words stimulate the economy by controlling the amount of money available to business and consumers. The second way money is controlled in the United States is through the fiscal policy. This policy differs from the monetary policy in a sense that is refers to efforts by the government to stimulate the economy directly through spending. The purpose of this paper will focus on how the federal reserve uses tools to control money, how those influences will effect the money supply and macroeconomic factors, how money is created and what combinations of monetary policy will help achieve a balance between economy growth, low inflation and a reasonable rate of unemployment.

One of the main responsibilities for the Federal Government is to regulate the money supply so as to keep production, prices, and employment stable. The "Fed" has three tools to manipulate the money supply. They are the reserve requirement, open market operations, and the discount rate. The first tool, the reserve requirement is the percentage of the deposits (at its vaults or with the Fed). The Fed mandates this ratio. If this ratio is decreased, banks are required to hold lesser amount as reserves and can lend that much more to their customers, thus increasing the money supply in the economy. The reserves is also true if RRR is increased this will decrease the money supply in the system, since, in trying to meet the requirements, banks end up draining the system. (University of Phoenix, 2007). The second tool the "Fed" uses is the discount rate. This tool mainly focuses on whether or not banks will need to borrow from the "Fed" or from other banks depending on whether or not there is an increase or decrease in the DR-FFR spread. Finally the third tool used by the "Fed" is called the Open Market system. The open market system is comprised of T-bills, bonds, and other federal instruments that are sold to investors (University of Phoenix). Selling of these instruments can lead to draining money out of the system, the opposite also holds true, buying of these instruments also released money into the system. Of the three instruments of monetary control, buying and selling securities in the open market is the most important. This technique has the advantage of flexibility--government securities can be purchased or sold in large or small amounts--and the impact on bank reserves is prompt. And, compared with reserve requirement changes, open-market operations work subtly and less directly (McConnell & Brue, 2004). These tools used by the Federal government can directly influence the money supply and macroeconomic factors.

Money supply can be defined as he amount of money in the economy, measured according to varying methods or principles. One such method incorporates only money that is usually used to purchase goods and services, such as cash and the contents of checking account (Answers.com, 2007). Having knowledge about money supply and the tools used by the Federal government will provide a clear understanding of how it can influence macroeconomic factors. Changes in money growth can impact the economy's performance. Looking at the short run it can affect employment rates, output and real economic growth variables. Looking into the future, the tools used by the Federal Reserve can determine the rate of inflation and it can also be instrumental in economic growth, price stability and other economic goals. Before looking at the effects of money supply on these economic factors, the creation of money should be well understood.

The U.S money supply comprises of dollar bills and coins issued by the Federal Reserve System and the public at commercial banks and other institutions such as savings and loans and credit unions holds Treasury and various kinds of deposits. These measures correspond to three definitions of money that the Federal Reserve uses: M1, a narrow measure of money's function as a medium of exchange; M2, a broader measure that also reflects money's function as a store of value; and M3, a still broader measure that covers items that many regard as close substitutes for money. (Schwartz, 1999-2002). The Federal Reserve is the most important determent of money supply. Here is how money is created and how this all works: The Federal Reserve requires commercial banks and other financial institutions to hold a sum of their deposits they accept. Financial institution holds this as cash or deposits in their vaults for the Federal Reserve. The Federal Reserve controls this money by either lending money to the banks or through open market systems. Through the open market system the Federal Reserve either increases or decrease the reverse. To increase the reserve the Federal Reserve buys the treasury by writing a check to it. The seller will then deposit the check into the account therefore, increasing the seller's deposit. The bank will then deposit the Federal Reserves check at the district bank therefore, increasing its reserves. The opposite is true for decreasing the reserves if the purchases check falls, then the bank reserves fall. (Schwartz, 1999-2002). Through the creation of money, the Federal Reserve uses monetary policy to see what effects it has on macroeconomic factors such as GDP, unemployment, and inflation and interest rates.

Monetary Policy can affect GDP in a short run situation. If in an open market a purchase leads to an increase in the money supply which will then in turn lead to a decrease in interest rates which leads to an increase in investment which leads to an increase in GDP. However, if an open market sale leads to a decrease in the money supply which leads to an increase in interest rates to a decrease in investments leads to a decrease in GDP. When the Fed lowers interest rates then the value of a dollar (deprecation) then the demand for the U.S. good rises then net exports raise the GDP. When the Fed raises U.S. Interest rates the value of the dollar rises (appreciation) then the demand for the U.S good decreases the then net exports fall then the GDP will fall. Even though monetary policy attempts to control the money supply, inflation can also occur. In the face of the excessive demand, producers and suppliers have incentives to raise their prices. As time goes by, prices spiral upward, leading to uncontrolled inflation during which dollars lose their value. The key to keeping inflation in check is to maintain stable interest rates and not let the money supply grow too rapidly (Reynolds, n.d.). Interest rates are determined by the supply and demand for money. Monetary policy controls the supply of money