Monetary Policy

Introduction

Americans live in a world that is to a great extent cashless. Consumers spend most of our money through credit and debit cards, checks; we pay our bills through the banks online bill payment services, and other abstract tools. In today’s Internet age, we the means are totally cashless. For the most part, gone are the days of Cash on Delivery; nonetheless, commerce does not operate in an isolated environment. When transactions are made, money changes hands; money is after all money and therefore, falls within the confines of the monetary system.

This paper will discuss the Monetary Policy and its effects on Macroeconomics, including the Gross Domestic Product, unemployment, inflation and interest rates. It will discuss the monetary system and explain how money is created. It will further discuss which combinations of monetary policy helps to best achieve a balance between economic growth, low inflation, and a reasonable rate of unemployment.

Additionally, this paper will discuss tools used by the Federal Reserve to control the money supply. Once the tools have been identified, it will explain how the tools are used to influence the money supply and in turn affect macroeconomic factors. “In the United States, the idea that government fiscal actions can exert a stabilizing influence on the economy emerged out of the Depression of the 1930s and the ascension of Keynesian economics. Since then, macroeconomic theory has played a major role both in the design of fiscal policy and in an improved understanding of its limitations” (McConnell & Brue, 2005, p. 214).

How Money is Created

The question “what is money?” may seem like a basic question is more complex than it seems on the surface. Money in its simplest terms is a medium for exchange and facilitates trade when wants do not coincide. “Money and time are both scarce and making decisions in the context of scarcity always means there are costs…Money produces nothing; it is not an economic resource. So-called money capital or financial capital is simply a means for purchasing real capital” (McConnell & Brue, 2005, p. 23).

The Federal Reserve Bank, more commonly known as The Fed, “conducts monetary policy by buying and selling U.S. Treasury securities. A board, which consists of a seven-member panel that creates the Board of Governors, governs the Federal Reserve System. In a sense, it may seem that the Fed creates money out of noting. When it buys the money supply expands; when it sells the money supply contracts. The vast bulk of the money created in the process consists of bank balances. Only a tiny percentage involves the printing of currency, which is done by the Treasury's Bureau of Engraving and Printing” (NCPA, n.d.). Only a small portion of U.S. money is in the form of bills or coins; the vast majority exists only as electronically in computers. “But to serve as money, an item needs to pass only one test: It must be generally acceptable to sellers in exchange for their goods and services” (McConnell & Brue, 2005, p. 64). The amount of money in the system may begin with the Fed, the banks or the general public, but the main control is the primary responsibility of the Fed.

Tools used by the Federal Reserve to Control Money Supply

How the markets respond to the Fed’s actions has been a subject of attention for some time. The Federal Open Market Committee (FOMC) is the most significant policymaking body of the Fed System. The seven Governors, the Federal Reserve Bank of New York president, and four other Reserve Bank presidents that serve on a rotating basis, make up the FMOC. The monetary policy can be affected by the FOMC through the use of three tools. The Fed will use these tools to control the amount of money or supply of money.

The first is the spread linking the Discount Rate (DR) to the Federal Funds Rate (FFR). Banks will make use of money from the Fed if the DR charged by the Fed is less than the FFR charged by other banks. The DR is the “rate of interest charged to banks on loans they receive from their regional Federal Reserve Bank's lending facility” (The Board of Governors of the Federal Reserve System, n.d.). The two are inversely related so that as the DR is decreased, so the spread is increased, banks change their source of borrowing from other banks to the Fed. As they do so, the quantity of money is in the system is increased. When the spread is positive, the DR is higher than the FFR; the banks will borrow from other banks and therefore have no effect on the supply of money.

The next tool used by the Fed is the Reserve Requirement. The reserve requirement is a ratio that is the percentage of a bank’s balance that the banks must have on hand to serve as a reserve; the Fed mandates the ratio. The required reserve is to make certain that banks do not run out of money to meet any potential withdrawal demands. Banks in turn loan the money they do not keep on hand to other customers. Knowing this, one can determine that when the required reserve ratio is decreased, money supply increases. “Not only do banks create money when they lend to the government; they create money when they lend to anyone!” (Parks, 1998). The reverse is also true. If the required reserve ratio is increased, money in the system will decrease as well because banks are trying to make up the requirement.

The third tool used by the Fed is Open Market Operations. The Open Market Operations is the “purchases and sales of U.S. Treasury and federal agency securities--are the Federal Reserve's principal tool for implementing monetary policy” (The Federal Reserve Board, n.d.). The Federal Open Market Committee (FOMC) determines the immediate purpose for open market operations. The goal can be a desired amount of funds for reserve, a desired price, or the FFR. The FFR is the rate of interest banks lends balances at the Federal Reserve to other banks overnight. The sale of the securities will normally drain money out of the system while the purchasing will put money into the system.

How the Tools Influence the Money Supply and Macroeconomic Factors

Simply stated, the tools that have been discussed can be used by the Fed to take money out of or put money into the economic system. The Fed has the responsibility of balancing the economy. The Fed will monitor such things as the Gross Domestic Product (GDP), interest rates, inflation and unemployment to ensure that the economy is healthy. For example, to control