Macroeconomic Impact
The Federal Reserve Board has three many tools that is uses to control the supply of money in the United States. These three tools are the reserve ratio, the discount rate and open-market operations. When the Fed uses thee tools they influence the money supply and affect macroeconomic factors. I will discuss how money is created and when it needs to be increased or decreased in supply. I will also discuss how the three tools the Fed uses affects our economy. I will discuss to specific monetary policies that combined that will achieve a balance between economic growth, low inflation and a reasonable rate of unemployment.
Current money is based on how money first came in to play. According to Hayne, Boettke & Prychitko, people did not like having to barter with gold and silver and other metals because it was hard to regulate the quality of the product as well as the fineness of it. Merchants and wealthy people who owned bars of gold and silver started looking for a place that would be safe to store them and in doing so found goldsmiths to be the solution. The goldsmiths issues receipts when securing the items and this was perhaps the first form of paper money.
“At this point the goldsmiths-embryonic bankers-used 100 percent reserve system; they backed their circulating paper money receipts fully with the gold that they held ‘in reserve’ in their vaults,” (McConnell & Brue, 2005, p.253).
Eventually goldsmiths realized that paper receipts could be issued in excess of the amount of gold held according to McConnell and Brue. Goldsmiths put into circulations these receipts by making interest-earning loans to merchants, producers and consumers. Everyone accepted loans in the form of gold receipts as a medium of exchange in the marketplace.
The basic condition of money is that everyone has to accept the form of currency as a medium of exchange without this acceptance no matter what anything is printed on or how it is printed it will have no value. What is currently in use today as the medium of exchange consists almost entirely of the IOUs of trusted institutions (Heyne, Boettke & Prychitko, 2006, p.400). The Federal Reserves notes are the combination of coins and paper money that has become the trusted medium of exchange.
There are three ways the Federal Reserve can control the money supply: changing the required reserve ratio, changing the discount rate and engaging in open market operations. The required reserve ratio establishes a link between the reserves of the commercial bank and the deposits (money) that commercial banks are allowed to create. If the Fed wants to increase the money supply, the Fed can decrease the required reserve ratio, which allows the banks to create more deposits by making loans.
The discount rate is the interest rate the Fed charges banks for short –term loans according to Heyne, Boettke & Prichtko. If a bank borrows from the Fed it leads to an increase in the money supply. If the discount rate is high, it will cost more to borrow money, which then leads banks to do less borrowing.
When the Fed purchases or sells government securities in the open market it is called open market operations. This is a tool that is used to increase or decrease the amount of reserves in the system and in turn the money supply. This tool is the most significant tool the Fed can use to control the supply of money. It can be used with a certain amount of accuracy, is flexible and is fairly predictable. Through the open market operations, the Fed can have the money supply be whatever value it wants.
How Money is created
The Fed can increase the supply of money by using its three most powerful tools and by doing this they are creating money. When expansionary monetary policy is in effect, decreasing the reserve ratio will give commercial banks the ability to lend to more customers. When the Fed decides to lower the discount rate, the Federal Reserve Bank will lend more money to the commercial bank which will increase the money supply by increasing the amount commercial banks have in reserve. This allows banks to have more available funds for lending. When the economy is showing signs of recession and unemployment, the Fed can buy securities to increase commercial bank reserves. The open-market operation is the most common tool used through the sale and purchase of government bonds.
“In addition, the Federal Reserve can use "moral suasion" by pressuring certain market participants to act in a particular manner or through "open mouth operations" where the Fed states what goal it will be focusing on in hopes of getting the market to build these future monetary actions into expectations and thus increase the effectiveness of the current monetary actions,” (Keefe, 2008).
Recommended Monetary Policy
When determining the levels of money supply the Fed uses the Monetary policy which is “the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy,” (Wikipedia, n.d.). According to McConnell and Brue, the advantages over fiscal policy are the speed and flexibility, and the isolation from political pressure. When the Fed uses the open-market operation to sell or purchase government securities daily to affect the money supply and interest rates, its affects are felt immediately. When adjusting a combination of discount rates and reserve requirements, the Federal Reserve Bank can influence how the monetary policy is used to achieve a reasonable balance between inflation and economic growth. During a recession, like in 1990s, using the Easy Money Policy would be a good way to try to jump-start the economy. The drawback in using this policy is that it can create too much money and spending. When this happens it can lead to inflation which needs to be curbed by the Fed who would reduce reserves in the banking system by raising interest rates (McConnell & Brue, 2005, p. 281). The Tight Money Policy incorporates the increase in interest rates with raising the discount rate and selling securities to decrease spending and control inflation. This two policies used correctly can help achieve an environment with a stable economy.
Economics for Managerial Decision Making
In the Monetary Policy simulation provided by the University of Phoenix (2009), scenarios were presented to students in regard to monetary policy. The simulation put a student in the position as the Chairman of the FED and required that person to make decisions with the tools available to the FED to control the supply of money. By using the tools the student gets to see how they affect the Real Gross Domestic Product (Real GDP), the Inflation Rate and the Unemployment Rate. These are the three main macro-economic indicators that can be affected by the money supply. In the one scenario the economy is in a slump, industrial production is slow and unemployment seems to be rising. Using all three tools available, I did not touch the Discount Rate (DR) and Federal Funds Rate (FFR) spread, decreased the Reserve Ratio to 9.1 and sold $500 million government securities in the Open-Market. The results of my choices were an increase in the Real GDP to 6.59% from 2.54%, inflation rose from 4.4% to 8.15% and unemployment decreased from 7.25% to 6.21%. By selling the securities, the supply of money went up which also increased inflation. When the Real GDP increases the usual result is a decrease in unemployment which is what happened in my scenario. This simulation made it possible to see how the monetary policy affects the economy and how the FED controls the supply of money through its three major tools.
Conclusion
The required reserve ration, the discount rate and the open-market operations are the three tools of monetary policy that the FED uses to control the supply of money. A combination of these tools will be used during a recession or growth through either an expansionary monetary policy or contractionary monetary policy. These policies will influence the commercial banks and anyone else who can create money. Banks will have more flexibility to lend money when the FED lowers the required reserve ratio also making them more willing to do so. When lowering the discount rate, the FED is allowing commercial banks to borrow more from the Federal Reserve Bank which increases the availability of money for lending. The open-market where government securities are bought and sold is the most common tool used and increases commercial bank reserves. This tool is used daily through the stock market. For the Fed to be able to act quickly in response to a combination of issues or individual issues like inflation, unemployment and economic growth, the monetary policy is policy that is used.
References
Heyne, P., Boettke, P. K. & Prychitko, D. L. (2006). The economic way of thinking (11th Ed). Upper Saddle River, New Jersey: Prentice Hall.
Keefe, T. (2008). How much influence does the Fed have?. Investopedia.com. Retrieved Month Day, Year, from http://www.investopedia.com/articles/stocks/08/monetary-policy.asp
McConnell, C.R. & Brue, S.L. (2005). Economics. Principles, problems, and policies (16th Ed). New York: The McGraw-Hill Companies.
Wikipedia. (n.d.). Monetary Policy. Retrieved July 29, 2009, from http://en.wikipedia.org/wiki/Monetary_policy
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