Macroeconomics



Macroeconomics

Monetary Policy

The word 'Monetary Policy' or the 'Credit Policy' links to the actions of the central banks through which it controls the money supply for the stability of an economy. The Central bank in United States is the Federal Reserve after the declaration of Federal Reserve Act of 1913. Mainly three tools of monetary policy are controlled by the Federal Reserve. Monetary policy sets objectives to influence the production of an economy (Federal Reserve Bank of San Francisco, 2011)

The Tools:

Open Market Operations

The Discount rate

Requirements of the Reserves

Among the three tools, the Open market operations are primarily controlled by Federal Open Market Committee (FOMC). Reserve requirements and the discount rates are directly controlled by Federal Reserves by stimulating the funds rate which directly affects the economy by influencing the chain of events occurred by the changes in the funds rate.

The Objectives:

Stability of price

Long term Interest rate

Employment at its maximum

Generally, the inflation, output or employment does not influenced by fed directly but it can directly affect the short-term interest rates or 'Federal fund rates' which influences them. Funds rate is that quantity of interest rate that banks in the overnight loans, charge each other and these charges depends on the supply and demand of reserves. Simply it is the quantity at which the banks in the surplus lend the money to the deficit banks by some negotiations. For instance, if the supply of reserves exceeds the demand for reserves in the federal funds market then the funds rate falls. Comparatively, if the supply of reserves is less than the demand for reserves then apparently the fund rate rises. (Federal Reserve Bank of San Francisco, 2011)

The effects of Monetary Policy:

Monetary policy achieves all its objectives by controlling the money supply by Federal Reserve which affects the aggregate demand, supply and inflation. Monetary policy influences the inflation and other things by stimulating the interest rate which directly affects them. Keeping the interest level high, decreases the inflation and making the economy stable which is one of the targets of monetary policy.

Aggregate Demand and Supply:

Changes in the interest rate affect the demands and spending decisions of the consumer and firms. If the interest rate is low it is comparatively cheaper for the consumers to spend their money and purchases the goods and for firms to invest their money. Similarly, if the interest rate is high it decreases the aggregate demand of the consumers and firms and they are less willing to spend their money. (Miller R.L., 2012)

To understand how monetary policy affects the aggregate supply and demand, we must suppose that the economy is at long run equilibrium level at point C. Suppose if this equilibrium level is disturbed by some shocks which cause the aggregate demand curve to fall to AD2 from AD1. At point B, the economy is below the natural rate of unemployment and is facing a contractionary gap. Monetary policy has two choices at this level of high unemployment and decline of output level.

To wait for the natural forces to ...