Inflation and Unemployment - Essay Example

Monetary Policy: A Tool to reduce Inflation and Unemployment Monitory policy is a tool for federal bank to control unemployment and inflation. But before going into the details of how monitory policy can be used for the two objectives, we will discuss some key terms which are of prime importance to understand the operation of federal bank. Assets Federal bank holds two types of assets, securities and loans. Securities are the instruments issued by government and a purchase by federal bank. Investment bonds, T bills are the two examples of such securities. These securities are floated by government when it needs to raise funds for its operations and investments. Loans are the amount of money that is lent by federal bank to commercial bank. Liabilities Reserves of commercial bank are one from of liabilities of federal bank .the imposition of reserve requirement from federal bank results this liability. Treasury deposits are also a liability for federal bank since there are the deposits made by treasury department of states. Federal Reserve notes are the notes circulated by federal bank in the country in the form of paper money. They are the claims against the assets of federal bank and hence become liability for federal bank. Tools of Monetary Policy Since, we know that one of the core functions of federal bank is the creation and control of money in the economy, the monetary policy acts as an action plan for this purpose. The federal bank has three core tools to control the money supply in the market Open Market Operations Since bonds are floated in the market by government and other organization to raise money, they can be used by the federal bank to increase or decrease the money supply. The federal bank can either buy or sell bonds with commercial bank or general public. Buying securities from commercial banks the reserve of commercial bank are increased while the assets base of federal bank increases. Same thing happens when the federal bank buys securities from public, the asset base of the federal bank increases as well as that of commercial bank. Overall the money at the disposal of federal bank increase which increases the money supply n the market. By selling securities to commercial bank or to public the federal bank dries out some part of the money from the market against the bond issued to the buyers of those securities. The Reserve Ratio Reserve ratio is the amount of reserve of commercial bank that they are required to keep with the federal bank. This reserve is not allowed to be loaned to the public. A federal bank, when want to increase money supply in the market decreases the reserve ratio which in turn decreases the reserve of commercial bank kept with federal bank. With the increase money at the disposal of commercial bank they are able to load out more money in the market which increases the money supply. Similarly if the federal bank wants to decrease the money supply it increases the reserve ratio requirement. The Discount Rate Since federal bank also acts as a lender of last resort, commercial banks come to central bank when they need money for short term purposes. Federal charges an interest payment over these lending from commercial banks. This interest is charged at a rate which is called the Discount Rate. If this discount rate is high, commercial banks will be reluctant to borrow from federal bank and hence their capacity to give out loans will decrease. How monetary Policy can be used in Recession and Unemployment? Suppose the economy is going through the phase of recession and unemployment. In such case there will be idle capacity at plants as well as idle labor force due to reduced production resulting in reduced demands from buyers. What Federal bank can do? It can increase the money supply in the market, which will increase the disposable income in the hands of customer. Customers will use this disposable income in their spending and thus creating demand for more products. The increase in aggregate demand needs to be fulfilled by increase in aggregate supply from the producer. This will utilize the idle labor force and idle capacity of plants. Federal bank can do the job by buying securities. To buy securities federal bank will give money to commercial bank or public in return. The greater amount of money will be available at the disposal of public which will increase the money supply, the spending from customers, aggregate demand, the amount of real output produced by the country and in turn more employment for the idle labor capacity in the economy. Moreover Federal bank can also lower the reserve requirement for commercial banks to increase money in the commercial which they can use to lend public. The increase money supply will decrease the price of money i.e. interest rates and it will easily be accessible by public to increase their spending. This will pull the economy out of recession and decrease unemployment. Fed can also lower the discount rate at which it lends money to commercial bank to pull the economy out of recession. The whole process of Federal Bank increasing money supply is called Easy Money Policy. How Monetary Policy can be used to reduce Inflation? The relaxed monetary policy i.e. excessive supply of money, leads to inflation. Inflation occurs when too much of money is chasing fewer goods. In that case people will be willing to pay higher prices for goods and hence the prices will rise. Now Fed using its tools of monetary policy can reduce this inflation to bring the prices back to nominal level. Federal bank can sell securities in the market which can be bought by commercial bank or public which will pay money to Federal Bank in return. This will reduce the money at disposal from commercial banks and public and with lesser money than previously they will be more intended towards saving rather than spending. The decrease in spending and increase in saving will reduce the aggregate demand of real output in the market. This decrease in aggregate demand will leave the inventory in shelves idle and hence the reduce demands for these products will reduce their prices. Federal Bank can also increase the reserve ratio requirements for commercial banks to accomplish the object. Increased reserve ration requirement will increase the commercial bank’s reserve with Federal Bank and decrease the money at Commercial banks’ disposal to lend out to public. Interest rates will high since lower amount of money with commercial banks will be needed by too many borrowers. This shortage of money will cause people to reduce their spending and the time comes when the aggregate supply will be far more than the goods demanded in aggregate by public. The excess of aggregate supply will cause the prices to come down to persuade customers for purchases. Federal bank can also increase the discount rate to create reluctance among commercial banks to stop borrowing from Federal Bank. This will reduce the lending side of commercial banks and hence spending and aggregate demand. This act of Federal Bank to dry out money supply from the market is known as Tight Money Policy. (Face web, 2007). Cause-Chain effect As the money supply will increase in the market, more money will be available to public to get loan of and hence the price of the money i.e. the interest rate will go down. Or as the price of the money increases the money being demanded and supplied in the economy will decrease. Similarly the rise in interest rate will make investors reluctant to make new investments in capital goods. Secondly if they do invest, they will require higher rate of return to make their project useful. (McConnell, 2002). Example is the money supply increases from S1 to S2, it means the price of money i.e. the interest rates will go down and the investment climate will foster. This increase in investments will shift the demand curve towards right. And hence with the increase in money supply the investment increases as it become easier for investors to take loan. The lower the price of money, the higher will be the demand of product and the demand curve will move towards right. This shift in demand curves also causes prices to go high, since the economy will still have the option to hire people which are unemployed and continue to do so where the actually vertical portion starts. Bibliography Face web, (2007). “Aggregate Demand and Supply”. Retrieved on April 25, 2007: http://facweb.furman.edu/~dstanford/macro/m7.htm McConnell, (2002). “Equilibrium: Real Output and the Price Level”. Economics by McConnell Brue. Fifteenth Edition. Mc Graw Hill. ISBN: 0-07-112322-9 Read More