Mba - 501 Monetary Policy

Monetary Policy

The Federal Reserve Bank constitutes the central banks in the United States that has three tools of monetary policy they can control the money supply to influence interest rates and total level of spending in the economy to maintain price-level stability, full employment and economic growth. They are Open-market operations, the reserve ratio and the discount rate. The Fed’s Open-market operations consist of the buying of government bonds from, or the selling of government bonds to, commercial banks and the public. Open-market operations are Fed’s most important instrument for influencing the money supply (McConnell-Brue, 2004, p.270). When Federal Reserve purchase government bonds or securities from commercial banks, increase the reserves of the commercial banks, then increases the lending ability of the commercial banks and they sell the securities, decrease the reserves of the commercial banks. Buying bonds increases the reserve banks will hold, this enables banks to lend more money and they can reduce lower interest rates while selling bonds effect higher interest rates and lower bond prices in the market.

Another tool is the reserve ratio that controls a power technique of money supply. The reserve ratio is a percentage of deposits that commercial bank holds as reserves. The Fed can mandate the reserve ratio in order to influence the ability of commercial banks to lend. Raising the reserve ratio can lead to a decrease in excess reserve and increase the amount of required reserves bank must keep. Lowering the reserve ratio can occur the opposite; increase excess reserves and enhances the ability of banks to create new money by lending. Reserve ratio affects the money-creating ability of the banking systems by changing the amount of excess reserves and the size of monetary multiplier.

The last tool is Discount Rate also called the interest rate that commercial banks charge interest on their loans, so too Federal Banks charge interest they grant to the banks. Borrowing from the Federal Reserve Banks by commercial banks increases the reserves of the commercial banks and enhances their ability to extend credit. A lowering of discount rate persuades commercial banks to get additional reserves by lending new reserves to increase money supply. The Fed can raise the discount rate when it wants to restrict money supply by increasing the discount rate. As the discount rate is decreased, banks shift their source of borrowing from other banks to the Fed. As they do so, the total amount of money in the system is increased. If the spread is positive, banks will always borrow from other banks, this will have no effect on the money supply.

When economy is facing recession and unemployment, the Fed decides to buy securities, lower the reserve ratio or lower the discount rate. Excess reserves will increase the supply of money to rise. Lower interest rate will cause more investment spending while the aggregate demand, output and employment will increase real GDP to rise by the multiple of the increase in investment. These actions are called an easy money policy or expansionary monetary policy. When the economy is facing inflationary, the Fed will do the opposite way of an easy money policy. The Fed must sell government bonds, increase reserve ratio or increase the discount rate. Excess reserves will decrease causing the money supply to fall. Higher interest rates can lead to decline investment spending and reduce aggregate demand by contracting the money supply. These actions are called a tight money policy or restrictive monetary policy (McConnell-Brue, 2004, p.275).

Buying government bonds will go real GDP rises by the increase in investment. So, unemployment rate will decrease because work production is going up due to more consumer demand. Moreover, lower interest rates are incentive for entrepreneurs to add more investment spending. Selling government bonds effects on lower real GDP, increase unemployment and interest rate because work production level is low due to less aggregate demand and inflation declines. Money is created by commercial banks or thrifts through lending that households and businesses are willing to borrow. When a bank makes loans, it also creates money. All commercial banks provide specified percentage checkable deposits in required reserves, by law. The specified percentage of checkable deposit liabilities that a commercial bank must keep as reserves is known as the reserve ratio. If commercial banks create money in the form of checkable deposits when they make loans, money is destroyed when loans are repaid. New money is created by a commercial bank buys government bonds from the public. Bond purchases from the public by commercial banks increase the money supply in the same