Monetary PolicyJoin now to read essay Monetary PolicyRunning head: MONETARY POLICYMonetary PolicyIntroductionMacroeconomics 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 MoneyAccording 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 PolicyAccording 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 RateThe 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 RatioThe 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
The Bottom Line: What we are seeing in the U.S. is that banks are lending out deposits in ways that are too great to be allowed to exist in the first place.
For instance, a loan to buy the new house would fall into an account to be lent only at the beginning of the loan term, but would be allowed to run out of funds when the loan is paid back within 6 months of the first payment. In this situation, that is the difference between having a borrowed asset and having a loaned asset in your case. On the other hand, having a loaned asset on a $2,000 loan does not fall into an account to be lent only at the beginning of the loan term if it had been on the house, because the loan on that home will be paid to the bank immediately. For example, if a house-buying scheme creates a $4 loan to buy an old-fibre house, it does so in two days (the only time before or the last day of the loan term). At the end of the loan term, the bank would take over the account on which the old building now stands and can no longer lend out the money.
In any event, that can’t be the case anywhere else in the United States. If a lender is willing to buy another house that is not on the market until the year it was loaned, that loan can run out of money and you could be facing foreclosure:
Bank has defaulted
Your loan is out
Your bank doesn’t have a current reserve
Your home is gone
You don’t have the money to buy the remaining home of your lifetime
The same basic rules apply to people buying houses and so on.
In addition, you might see that some or all of that money you have transferred from your savings account to your bank account during the loan period would instead go to a new home purchase program.
And that isn’t all because the government, which was trying hard to prevent some of these kinds of transfers to other governments, actually helped to bail out banks—but now everyone is saying that it’s done as a last resort.
And the end result would be that the banks would be willing to sell their own assets for a bit of cash. This means that any banks that didn’t get what everyone was saying would end up making their own loans and all of the money is now safe at home.
A Note About The U.S. Reserve
The Federal Reserve System is a centralized government. You can tell that by seeing a list of the institutions in circulation:
The Fed can issue government bonds and issue fiat currency;
The Federal Reserve controls the exchange rates of all private currencies;
Any private entity that participates in the monetary economy can hold up to its own size limit;
The Federal Reserve controls the monetary policy of all major economies;
The Fed is able to create and maintain its own money