Running head: MONETARY POLICY/MACROECONOMIC IMPACT PAPER
Monetary Policy/Macroeconomic Impact Paper
University of Phoenix
The Federal Reserve Board (FED) utilizes tools to control or manipulate the money supply, these tools affect macroeconomic factors such as inflation, unemployment and interest rates, which ultimately determine a country’s GDP. To recommend the best monetary policy combination I will discuss the tools used by the feds, explain how money is created and also illustrate the effect of the money supply on the economy. It is the money supply which determines the rate of inflation, unemployment and economic growth.
Tools Used by The Federal Reserve To Control Money Supply.
The Fed has three main tools for controlling the money supply these are their Open Market Operations, The Discount Rate, and The Reserve Ratio. These tools can be used to alter the reserve ratios of the commercial banks which in turn determine the money supply. “The money supply consists of currency (Federal Reserve Notes and coins) and checkable deposits. The U.S. Burea of Engraving creates Federal Reserve notes and the U.S. Mint creates the coins.”(McConnell & Brue 2004) “By purchasing government bonds, (securities) the Fed increases the reserves of the banking system which then increase the lending ability of the commercial bank,”(McConnell & Brue 2004) and the money supply available. Selling bonds will also achieve the opposite results namely reduce the money supply by reducing the reserves of the bank.
The central bank desires to be a lender of last resort. When the commercial bank borrows it gives the Fed a promissory note drawn against itself and secured by acceptable collateral. The Fed charges interest on the loans which is called the discount rate. The new reserve obtained by borrowing from the Fed immediately becomes excess reserves as no required reserve needs to be kept for loans received from the Fed. Thus by reducing the discount rate, commercial banks can be encouraged to borrow from the Fed which directly increases their excess reserves and their ability to lend, so the money supply is increased. The opposite can also be done to reduce the money supply.
The Fed can also manipulate the reserve ratio as a means of affecting the ability of commercial banks to lend. If the Fed increases the reserve ratio the commercial bank is forced to reduce its checkable deposits in order to increase its reserves to the new minimum requirement. It might also be forced to sell some bonds in order to increase its required reserves, and both scenarios would result in a reduction of the money supply. By lowering the reserve ratio the commercial banks reserve is transformed into excess reserve which increases the banks capability of lending, which increases the money supply.
“Interest rates in general rise and fall with the federal funds rate. The prime interest rate is the benchmark rate that banks use as a reference point for a wide range of interest rates on loans to business and individuals.” (McConnell & Brue 2004) Therefore when the Fed changes the discount rate it also changes the prime interest rate. A lower discount rate is passed on to consumers who then are able to obtain lower interest rates for mortgages and credit cards which increases their disposable income. This higher disposable income then results in more demand for goods and services which causes an increase in the supply of these goods to meet the increasing demand. Also an increase in the money supply and more money to lend by the banks result in more credit for businesses who are then able to purchase more materials to produce more or invest into the expansion of their businesses. The end result is that more goods and services are being produced as a result of the increase in money supply, which is beneficial to the country’s GDP. “In brief, the impact of changing interest rates is mainly on...
References: Bankers Research Institute, The Wizards of Money Part 1: How Money Is created. Retrieved
April 26, 2010 from http://www.altruists.org/static/files
McConnell, C. & Brue, S. (2004). Economics: Principles, Problems, and Policies, 6th ed. McGraw-Hill Irwin.
Monetary Policy Report to the Congress, July 21, 2009. Retrieved April 26, 2010 from
University of Phoenix. (2010). Simulations Monetary Policy [Computer Software].
Retrieved from University of Phoenix, Simulation MMPBL 501 website.
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