Monetary Policy

According to the simulation, there are three key economic tools used by the Federal Reserve to control the monetary policy.

1. Spread between the Discount Rate and the Federal Funds Rate

2. Required Reserve Ratio

3. Open Market Operations

These economic tools influence the money supply in the following ways:

1. Difference in Discount Rate and Federal Funds Rate:

Banks are able to borrow from the Fed if the discount rate charged by the Fed is lower than the federal funds rate charged by other banks. As the discount rate is decreased, banks shift their source of borrowing from other banks to the Fed. As they do so, the total amount of money in the system is increased. If the spread is positive, banks will always borrow from other banks, this will have no effect on the money supply.

2. Required Reserve Ratio:

The percentage of deposits any bank holds as reserves. The Fed mandates the ratio. When the ratio is decreased, banks are required to hold a lower percentage than reserves and can lend more to their customers, in-turn increasing money supply in the economy. The opposite can occur, causing banks to drain the system due to the decreased money supply.

3. Open Market Operations:

Items such as T-Bills and bonds are sold to investors through auctions. Sale of these instruments drain money out of the system, where as buying these items will release money into the system.

The three tools that affect the money supply will also affect three macro-economic indicators. The three indicators are the Gross Domestic Product, the Inflation Rate, and the Unemployment Rate.

1. Gross Domestic Product:

The Gross Domestic Product will increase with increasing money supply. High levels of money in the system will spur on investment and industrial consumer demand. Any measure that drains money out of the system acts as a disincentive to lower spending and investments; this will lower the Gross Domestic Product.

2. Inflation Rate:

While increasing the money supply is a good sign for the GDP, it is not the same for inflation. With the increase, the nominal value of money stays the same, but the increase in money continues to chase the same quantity of goods and services...thus the real value of money is decreased. The result is prices go up.

3. Unemployment Rate:

The unemployment rate reacts to the GDP. When investment and spending increase, demand and employment opportunities tend to go up due to labor requirements for production of goods and services. This increase causes a decrease in the unemployment figures. When money is reduced in the system, causing a decrease in the GDP, the employment opportunities and demand for workforce will fall increasing the unemployment rates.

Monetary Policy

U.S. monetary policy affects all kinds of economic decisions people make in this country as well as others. Whether it is to get a new loan for a brand new car, that new home for upstart family or to begin a new entrepreneur company, loans are a part of everyday life. Loans are not the only items driving the economic decisions, take for instance the money one puts in the bank or in bonds, some may even look to invest in the stock market. Because the U.S. is the largest economy in the world, its monetary policy can significantly affect financial endeavors in other countries.

The purpose of monetary policy is to control the performance of the economy in such areas as economic output (GDP), inflation and employment. Monetary policy affects the demand across the entire economy; this tends to align with an individual's willingness to spend money on particular good and services.

Many people are more familiar with fiscal policy items, which use tools such as taxes and government spending to control the economic decisions. Monetary policy is least familiar to many Americans as well as its tools for controlling economic issues. The Federal Reserve System, our nation's central bank, influences the demand of the economy by raising and lowering short-term interest rates for banks to borrow.

Monetary policy has two primary actions to achieve...it needs to promote sustainable employment and output with reasonable but stable pricing. These two primary goals originated through an amendment to the Federal Reserve Act.

The amount of goods and services that an economy produces as well as the jobs it generates, depend on many other factors than monetary policy alone. Other factors effecting output and employment include technology, methods of saving money and how much effort workers put forth in their daily jobs. Sustainable output and employment should be interpreted, as factors remaining consistent over a long run.

There are many situations when the economy cycles above and below the long-run initiatives. Even monetary policy cannot affect output or employment in the end, its measure is to affect output and employment in the short term. Take for instance, demand weakens and a recession occurs, the Fed will stimulate the economy only for a short bit and shift it back in line with the long-run level of output through the reduction of interest rates, hence the short-run objective for stabilizing the economy.

Our nation's demand for money comes through consumers borrowing for such items as cars and homes, companies borrowing for equipment in factories and government borrowing to finance our nation's debt. The amount of money in the system is driven by the decisions made by the Federal Reserve Board of Governors. This group is known as the central banking system