Monetary

Monetary Policy Paper 1

Monetary Policy Paper

Chris Limon

MBA 501

Donna Danns

September 26, 2006

Monetary Policy Paper 2

Introduction

Fiscal and monetary policies focus on quickly returning the economy to sustainable, healthy growth. Any type of fiscal relief package will boost consumer and business spending and can augment the nation's long-term growth potential. Expansionary monetary policy can stimulate growth and provide insurance against the possibility of deflation. This paper will present information on four topics: (1) tools used by the Federal Reserve to control the money supply, (2) how these tools influence the money supply and in turn affect macroeconomic factors? (3) how money is created? (4) recommended monetary policy combinations that best achieve a balance between economic growth, low inflation, and a reasonable rate of unemployment.

Monetary policy is usually administered by a Government appointed "Central Bank", the Bank of Canada and the Federal Reserve Bank in the United States. According to the Encarta the definition of monetary policy is the following economic principles and programs adopted by a government that manage the growth of its money supply, the availability of credit, and interest rates. In the United States, the Federal Reserve Board determines monetary policy.

Fiscal policy is the use of the government budget to affect an economy, Weils points out that when "the government decides on the taxes that it collects, the transfer payments it gives out, or the goods and services that it purchases, it is engaging in fiscal policy" (1). As Weils (2002) further explains, "the primary economic impact of any change in the government budget is felt by particular groupsÐ'--a tax cut for families with children, for example, raises the disposable income of such families. Discussions of fiscal policy, however, usually focus on the effect of changes in the government budget on the

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overall economyÐ'--on such macroeconomic variables as GNP and unemployment and inflation" (1).

Tools used by the Federal Reserve to control money supply?

On The Federal Reserve Web site"The major tool the Fed uses to affect the supply of reserves in the banking system is open market operationsÐ'--that is, the Fed buys and sells government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York. When the Fed wants the funds rate to rise, it does the reverse, that is, it sells government securities. The Fed receives payment in reserves from banks, which lowers the supply of reserves in the banking system, and the funds rate rises" (http://www.frbsf.org/publications/economics/letter/2004/el2004-01.html#subhead2).

Another tool the Fed uses to affect the supply of reserves The Fed can't control inflation or influence output and employment directly; instead, it affects them indirectly, mainly by raising or lowering a short-term interest rate called the "federal funds" rate. Most often, it does this through open market operations in the market for bank reserves, known as the federal funds market (http://www.frbsf.org/publications/economics/letter/2004/el2004-01.html#subhead2).

The Fed can also use discount interest rate decreases as way of controlling money: The Fed can lower the discount rate and lower the costs for banks holding low excess reserves which will lower the excess reserve rate. If the Fed lowers the discount

rate, or sets a lower federal funds target, this can be accomplished if the Fed injects funds into the system which will drive down the price of those funds - interest rates. To see

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how it could increase the level of cash in the system, we can turn to the next Fed tool - open market operations (http://www.frbsf.org/publications/economics/letter/2004/el2004-01.html#subhead2).

Tools that influence the U.S. money supply?

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 don't 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 (Colander, 2004, p. 225).

Monetary policy is one of the tools that a national Government uses to influence its economy. Using its monetary authority to control the supply and availability of money, a government attempts to influence the overall level of economic activity in line with its political objectives. Usually this goal is "macroeconomic stability" - low unemployment, low inflation, economic growth, and a balance of external payments. Monetary policy is usually administered by a Government appointed "Central Bank", the

Bank of Canada and the Federal Reserve Bank in the United States. According to the Encarta the definition of monetary policy is the following economic principles and

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programs adopted by a government that manage the growth of its money supply, the availability of credit, and interest rates. In the United States, the Federal Reserve Board determines monetary policy (Colander, 2004, p. 413).

How money is created?

The process begins with the Fed who controls the amount of currency that gets into the system. Actually it is the mint, an arm of the US Treasury Department that prints the money and then sends it to the Federal Reserve, but that is a finer point we need not concern ourselves with at this time. It is the Fed who puts the money into the system and the currency it supplies is called high-powered