Monetary Policy

Running head: MONETARY POLICY

Monetary Policy

Introduction

Macroeconomics is the study of the behavior of the economy as a whole and consists of numerous factors such as national output (measured by gross domestic product or GDP), unemployment, inflation rates, and interest rates. The following paper will discuss monetary policy and its effect on the macroeconomic factors. This paper will begin, however, by detailing the creation of money and then end with a description of the monetary policy combinations required to best achieve a balance between economic growth, low inflation, and a reasonable rate of unemployment.

Creation of Money

According to McConnell & Brue, “the narrowest definition of the U.S. money supply is called M1” (2004) and consists of the currency and all checkable deposits. Currency is embodied by the physical tender in the hands of the public – Federal Reserve Notes, created by the U.S. Bureau of Engraving, and coins, created by the U.S. Mint. The creation of checkable deposits is accomplished, contrary to logical assumptions, through loans issued by commercial banks and thrifts. The method in which this is accomplished is in lending money in response to an IOU note. A consumer or business, for example, may request to borrow funds from a bank in the amount of $10,000. A review of credit history and the current financial portfolio allows the bank to accept the borrower’s promise to pay plus interest in exchange for the money. The borrower offered no money to the bank yet walked out with an additional $10,000 – money has been created. This may sound absurd or sketchy, but is possible due to the reserve ratio (explained in more detail later). This ratio simply states the amount of money a bank must keep in reserve in relation to the amount of money it may lend out.

Monetary Policy

According to McConnell & Brue, monetary policy “consists of deliberate changes in the money supply to influence interest rates and thus the total level of spending in the economy” (2004, p.268). The deliberate changes that the Federal Reserve institutes alter the reserves of commercial banks through three tools: the Discount Rate, the Reserve Ratio, and open-market operations.

Discount Rate

The Discount Rate describes the interest rate at which the Federal Reserve lends to commercial banks. This rate differs from the Federal Funds Rate, which is the rate at which banks (and other private depository institutions) lend money to other banks (or other private depository institutions). A negative spread between the Discount Rate and the Federal Funds Rate, which occurs when the Discount Rate is lower than the Federal Funds Rate, signals an opportunity for banks and other institutions to borrow money at a lower than normal interest rate. This increased borrowing from the Federal Reserve introduces more money into the system; as McConnell & Brue describe it, “borrowing from the Federal Reserve Banks by commercial banks increases the reserves of the commercial banks and enhances their ability to extend credit” (2004).

Lowering the Discount Rate is a factor of Easy Money Policy (or Expansionary Monetary Policy). The purpose of this policy is to increase aggregate demand, output, and employment – all to combat economic recession and rising rates of unemployment. Raising the Discount Rate has the opposite effect and is a factor or Tight Money Policy (or Restrictive Monetary Policy), which is primarily used to reduce spending and control inflation. The Discount Rate has a direct influence in control of the money supply by making it easier or harder for commercial banks to increase their reserves and, in turn, the amount of credit available to extend to borrowers.

Required Reserve Ratio

The Required Reserve Ratio is the percentage of the deposits that banks must hold as reserves. In essence, the reserves are designed to satisfy withdrawal demands. A bank that lends out 100% of its funds has no ability to give deposits back to the consumer. If a bank maintains checkable deposits of $100,000, a current reserve of $20,000, and the required reserve ratio is 10%, then the amount required to be held as reserve is $10,000. This leaves the bank $10,000 in excess reserves that may be used for lending purposes. Manipulation of this ratio has a direct effect on a bank’s ability to lend. A rise in the required reserve ratio would translate to reduced excess funds in the reserve and, in turn, reduced availability of funds to lend. The opposite