Macroeconomics

Introduction

The example of the great depression during the thirties is a great example of how governments most make the best decisions when it comes to the economy. Conditions can change drastically and therefore lead to a recession with low employment rates or an increase in inflation. With the use of the Federal Reserve, changes within the economy can be seen faster than fiscal policies can. The role of the Federal Reserved is to monitor the supply of money within the economy. The tools available to the Federal Reserve are what steers the economy in the direction preferred. Within this paper I will identify how money is created to circulate within the population, as well as provide insight to what monetary policies are available to the federal reserve to help stimulate the economy.

Creation of Money

Gold is the beginning source of the concept of money as we know it today. During the 16th century goldsmiths would hold gold for traders for a fee and a receipt would be given to the trader, what evolved from this practice is traders would exchange receipts in place of their gold. These practices eventually lead to goldsmiths lending receipts to traders and the like for interest on the loan provided, increasing the income of the goldsmith. U.S. banks today follow a similar practice that is regulated by the federal government. In essence commercial bank and thrift loans create money. Today instead of gold on reserve, a certain percentage of currency is held within the bank for reserve. This is called required reserves, “which is the amount of funds equal to a certain percentage of the banks own deposit liability” ( McConnell & Brue, pg. 6, chap. 14, 2004). These reserves thought may appear substantial, will not with stand the cash withdrawal of funds from all customers who have checkable deposits, this can lead to the ruin of such an institution. The theoretical aspect of this concept of creation of money by lending or borrowing is the belief that banks want to lend money that consumers want to borrow. The system of commercial banking is regulated by Federal Reserve Banks or grouped together as the U. S. “central bank”( McConnell & Brue, pg. 1, chap. 15, 2004). These regulations are monetary policies. A monetary policy is the management of money supply that influence interest rates that then influence spending within the economy (McConnell& Brue, pg. 1, chap. 15, 2004).

Monetary policy

In order to control money supply the Federal Reserve has several tools in place. These tools are open markets, discount rates, and reserve ratio. Part of an open market the Federal Reserve buys and or sells securities in order to regulate money supply within the economy. These securities are open for individual purchase or commercial and thrift banking. This can be considered the most important instrument the Federal Reserve has for influencing the supply of money within the economy. This is due to the flexibility of setting the amount to be purchased or bought. The second tool used to regulate money supply is discount rates. Occasionally commercial bank will need to borrow funds from the Federal Reserve. The Federal Reserve then charges the commercial bank an interest rate that is called a discount rate. The control of the discount rate can influence the funds a commercial bank has in reserve to then offer loans to the population. A decrease in rate can encourage a commercial bank to borrow more while a increase in the discount rate will do the opposite. The third tool available to the Federal Reserve is reserve ration, which is the percentage of currency reserve a commercial bank is to have at all times. The reserve ration directly affects the amount a commercial bank can lend to the population. These can be used within a economic recession and unemployment. During such an occasion the Federal Reserve can purchase securities, lowering reserve ratio, and lower the discount rate. The purchase of securities within the open market can cause the commercial banks to have increase reserve money in order to then lend out more money to the population. This is done