Monetary Policy

Monetary Policy

Monetary policy is the procedure of managing the money supply to control interest rates and the total level of spending in the economy. The goal is to achieve and maintain price level stability, full employment and economic growth. (McConnell-Brue, p.268) Monetary policy effects every purchasing decision consumers make, whether to purchase a new home, start a new business, invest in the stock market or in a savings account. Through this exploitation of the money supply, government influences other factors such as GDP, inflation and the unemployment and interest rates.

Gross Domestic Product (GDP) is the total market value of all final goods and services produced in a given year. Final goods are goods and services that are purchased for final use by the consumer, not for resale or further processing or manufacturing. (McConnell-Brue, p. 112-113) Higher levels of money in the economy lead to a higher GDP.

Unemployment is defined by the following three groups: 1) people who are institutionalized and are not considered a member of the workforce, 2) people who are willing to work but are unemployed and are not seeking work and 3) people who are willing to work and those actively looking for work. An increase in spending leads to demand and employment opportunities going up which makes the unemployment rates decline. As money is drained out of the system, GDP and employment falls which increases the unemployment rate.

The unemployment rate is the percentage of the labor force unemployed. The present unemployment rate is 4.9 percent. Federal Reserve Board Chairman Bernanke said "the Fed's baseline is for a 5.2-5.3 pct unemployment rate by the fourth quarter of this year, but warned of the downside risks to the economy which could cause it to go higher."(Thomson Financial News Limited 2007, 2008)

Labor Force Statistics from the Current Population Survey

Series Id: LNS14000000

Seasonal Adjusted

Series title: (Seas) Unemployment Rate

Labor force status: Unemployment rate

Type of data: Percent

Age: 16 years and over

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual

1998 4.6 4.6 4.7 4.3 4.4 4.5 4.5 4.5 4.6 4.5 4.4 4.4

1999 4.3 4.4 4.2 4.3 4.2 4.3 4.3 4.2 4.2 4.1 4.1 4.0

2000 4.0 4.1 4.0 3.8 4.0 4.0 4.0 4.1 3.9 3.9 3.9 3.9

2001 4.2 4.2 4.3 4.4 4.3 4.5 4.6 4.9 5.0 5.3 5.5 5.7

2002 5.7 5.7 5.7 5.9 5.8 5.8 5.8 5.7 5.7 5.7 5.9 6.0

2003 5.8 5.9 5.9 6.0 6.1 6.3 6.2 6.1 6.1 6.0 5.8 5.7

2004 5.7 5.6 5.8 5.6 5.6 5.6 5.5 5.4 5.4 5.5 5.4 5.4

2005 5.2 5.4 5.2 5.1 5.1 5.0 5.0 4.9 5.1 5.0 5.0 4.8

2006 4.7 4.7 4.7 4.7 4.7 4.6 4.7 4.7 4.5 4.4 4.5 4.4

2007 4.6 4.5 4.4 4.5 4.5 4.6 4.7 4.7 4.7 4.8 4.7 5.0

2008 4.9

(Bureau of Labor Statistics, 2008)

Inflation is a rise in the general level of prices. Each dollar spent buys fewer goods. An increase in the money supply increases the inflation rate. A decrease in the money supply decreases the inflation rate. The Consumer Price Index (CPI) is used to measure inflation. CPI takes a basket of some 300 household items that consumers purchase and reports the cost for a certain period and compares the same basket of goods to the base year. Demand-pull inflation occurs when total spending exceeds the economy's ability to provide goods at the existing price level which pulls the price upward. Cost-push inflation explains rising prices in terms of factors that raise per-unit production costs (McConnell-Brue, p.142-143) Because of the rise in oil prices the cost of producing all other products consumers purchase will increase.

Current Inflation Rate

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Ave

2008 4.28% NA NA NA NA NA NA NA NA NA NA NA NA

2007 2.08% 2.42% 2.78% 2.57% 2.69% 2.69% 2.36% 1.97% 2.76% 3.54% 4.31% 4.08% 2.85%

2006 3.99% 3.60% 3.36% 3.55% 4.17% 4.32% 4.15% 3.82% 2.06% 1.31% 1.97% 2.54% 3.24%

2005 2.97% 3.01% 3.15% 3.51% 2.80% 2.53% 3.17% 3.64% 4.69% 4.35% 3.46% 3.42% 3.39%

2004 1.93% 1.69% 1.74% 2.29% 3.05% 3.27% 2.99% 2.65% 2.54% 3.19% 3.52% 3.26% 2.68%

2003 2.60% 2.98% 3.02% 2.22% 2.06% 2.11% 2.11% 2.16% 2.32% 2.04% 1.77% 1.88% 2.27%

2002 1.14% 1.14% 1.48% 1.64% 1.18% 1.07% 1.46% 1.80% 1.51% 2.03% 2.20% 2.38% 1.59%

2001 3.73% 3.53% 2.92% 3.27% 3.62% 3.25% 2.72% 2.72% 2.65% 2.13% 1.90% 1.55% 2.83%

2000 2.74% 3.22% 3.76% 3.07% 3.19% 3.73% 3.66% 3.41% 3.45% 3.45% 3.45% 3.39% 3.38%

(InflationData.com, 2008)

The interest rate is the opportunity cost of holding money as an asset; the higher the cost, the smaller the amount of money the public wants to hold. . (McConnell-Brue, p.277) Monetary policy helps to establish the interest rate. Changes in the interest rate can cause consumer to refrain from purchasing large items like automobiles and homes. Economists are predicting the Fed with cut interest rates half a point to .50 at the next meeting in March. This would mean the Fed has cut the interest rate over 3.00% in the last six months. Many believe this will be the last cut for the near future because of recession worries.

Creation of Money

Banks create money through the process of lending. Company A deposits $10,000 in Bank Q. Bank Q is required to keep 25% as their reserve requirement. Bank Q would then be able to loan $7,500 and they would