Money and Monetary Policy



Money and Monetary Policy

a. What are the tools used by the Federal Reserve to control the money supply?

The Federal Reserve Board uses tools to control the money supply in the United States, which are open-market operations, the reserve ratio, and the discount rate. These tools influence the money supply and affect macroeconomic factors, which I will discuss in detail. I will also explain how money is created in a macroeconomic system, and recommend monetary policy combinations to best achieve a balance between economic growth, low inflation, and a reasonable rate of unemployment. (Brue 2004)

Feds Tools of Monetary Control

The Fed has three tools that are used for monetary control in altering the reserves of commercial banks. The money supply is the total amount of currency plus deposits held by the public. These tools can alter economic growth, change the rate of inflation, the level of employment, and adjust the exchange rate, by expansionary or contractionary monetary policy. (Federal Reserve Bank of San Francisco 2004)

Open-Market Operations

The amount of money circulating in the economy can be adjusted through open-market operations, specifically with selling and purchasing of U.S. Treasury and federal agency securities bonds in the bond market. The Federal Open Market Committee (FOMC) will decide on a short-term objective for open market operations. This objective can be a chosen quantity of reserves, or a desired price (federal funds rate). The federal funds rate is the interest rate at which commercial banks lend balances at the Federal Reserve to other depository institutions overnight.

The Reserve Ratio

The Fed has control over the reserve ratio, which determines the lending ability of commercial banks. The reserve ratio stipulates how much a bank is required to keep in reserves relative to what is in deposits. If a bank has a reserve ratio of 15%, the required reserve on $10 million in deposits is $1.5 million. The required reserve ratio is dictated to be certain banks do run out of cash on hand to meet the demand for withdrawals. The money not required in be on hand is then loaned out to customers, which in turn, increases the money supply.

The Discount Rate

The Federal Reserve Bank is a lender of money to commercial banks. When commercial banks borrow from the district central bank with a promissory note, the interest charged is referred to as the discount rate. The borrowed money will then increase the commercial bank's reserve, which increases their lending ability. The discount rate is determined by the Fed, and this will be the cost of attaining the reserves. If the Fed were to lower the discount rate, more commercial banks would be inclined to borrow to obtain additional reserves, which would lead to more money in the economy. The same works in reverse for decreasing the money supply. (Friedman 1968)

Creation of Money

Using the tools previously identified, the Fed can increase the supply of money, in other words, create money. During a period of expansionary monetary policy, decreasing the reserve ratio will result in ...