Tools Used by the Federal Reserve to Control the Monetary Supply - Essay Example

TABLE OF CONTENTS PAGE NO What are the tools used by the Federal Reserve to control the monetary supply……………………………………… 2 2. How do these tools influence the money supply and in turn affect macroeconomic factors? ………………………….. 2 3. Discuss monetary policy and its effect on macroeconomic factors such as GDP, unemployment, inflation, and interest rates…….. 2 4. Explain how money is created………………………………………… 7 5. Which combinations of monetary policy help you to best achieve a balance between economic growth, low inflation, and a reasonable rate of unemployment? ...................................................... 8 List of references………………………………………………………… 9 MONETARY POLICY 1. What are the tools used by the Federal Reserve to control the money supply? There are three methods used by the Federal Reserve to control the money supply. First is thru the open market operations which are done through the buying and selling of U.S. government securities. Second is by changing the reserve requirements of banks. Reserve requirements are the amount of funds that commercial banks must hold in reserve against deposits, and third, is by changing the discount rate or interest rate charged to commercial banks.( Shad Satterthwaite) 2 How do these tools influence the money supply and in turn affect macroeconomic factors? These tools are used to increase or decrease money supply. For example, when the government wants to control inflation, the Federal Reserve can sell government securities to raise money. This money will be used to alter banks’ reserve thereby reducing money circulation. When there is a smaller supply of money, there would be less to spend which would eventually lower the prices of goods. Federal Reserve may also increase interest rates making it more expensive to borrow. In this case, consumers will rather save which in turn will result to lowering of prices. The reverse process can be done to increase money supply. 3. Discuss monetary policy and its effect on macroeconomic factors such as GDP, unemployment, inflation, and interest rates The effect of monetary policy can be described in the following scenario. To the man on the street, monetary policy doesn’t make sense; news about easy or tight money could go unnoticed, for after all, he receives exactly the same take home pay, eat the same food on the table, and can still purchase the same amount of goods on credit. However, let us consider this situation in business places where “easy” and tight” money could be readily observed. At one time or the other, we see offices busy with extra activities, while in another setting, we see the office like nothing is happening. Upon study, we see that the extra activities are brought about by expansion plans made possible by the easy monetary policy for investments. On the other hand, when money is tight, business activities are almost idle and there are no plans for expansion. What is a monetary policy? Monetary policy is a move to regulate the supply of money that causes upward or downward changes in the amount of funds available to investors and producers. To regulate the supply of money, the Central Bank Federal Reserves must strike a balance between the demands for fund for growth and requirements of stability. As needed by the economy, monetary policy may be done through a contraction or expansion. Monetary policies work in a cycle that should match the economic requirements for money supply. The Easy and tight money policy. Let us look at the picture of an easy and tight money policy. The basic objective of monetary policy is growth. In a situation when the dollar reserves are too high, prices of commodities are relatively stable, manpower and machineries are idling for non-use, what should the monetary policy be? Villegas, B. (p. 386) in his “Guide to Economics…” stated that lowering interest rates, providing an easy access to funds and giving attractive credit terms will spur economic growth. When there is more money in the hands of investors, new machinery will come in, and there will be more new investments thereby adding productivity to the existing production. As a result of productivity, more people will be employed, wages will be paid and more purchasing power will be made and a multiplier effect will result to higher GDP. In the financial market, lower rates makes investments in stocks more attractive than bonds, as a result common stock prices will rise. There will be an increase in wealth of households and investors when they find that the value of their common stock market is rising; this makes them willing to spend more. For business, higher stock prices make investments more attractive and enables company to develop their plant, equipment and machinery. As the business cycle works, and business expands, there will be more requirement for imported inputs for production, and the following circumstances will most likely to happen. The dollar reserves of the country will decline due to the heavy requirement for imported inputs for production. Next, when consumers have more money for spending, they buy more goods and services that eventually lead to a rise in prices. And then, when employment is full workers demand higher wages without necessarily increasing productivity. In this situation, the government puts a brake, and changes gear towards tight money policy because of its objective of maintaining stability and high level of international reserves. In the above state, monetary policy should be done cautiously. There should be an attempt to stabilize the money supply with production, income and investment. A very long period of tight and long period of easy policy requires a sense of balance as both affects the economy. What does contractionary and expansionary monetary policy mean to us? Mofatt, M. (no date) who made a study on the effects of monetary policy, described it as either in the form of contraction or expansion, in which either case involves the change in the level of the money supply in the country. Expansion increases while contraction decreases the supply of a country’s currency. As we can see, contraction effect is a reverse of the expansionary policy. In the United States (source) when the government needs to restrict money supply, it resorts to selling of securities in the open market; increase of the Federal discount rate and rising of Bank Reserves requirement. Any monetary policy produces a multiplier effect that is felt by investors. This means selling of bonds raises interest rates and decreases bond prices. With high interest rates, level of capital investment is lowered. As there is a low price for bonds and high paying interests, demand for local currency to buy bonds goes up, while demand for foreign currency falls. Since there is a rise of demand for currency, and the subsequent falling of demand for foreign currency, there will be an increased in the exchange rate. A higher exchange rate may be good for imports but causes additional costs to exporters. It causes exports to decrease and imports to increase. The effect of monetary policy to GDP The tight money policy of the Fed Reserve after the economic crisis resulted to large monetary reserves. Could this be an indication of growth? Apparently, a large monetary base is not an indication of growth. The study of Yi Wen (2008), an Economist said that he “wanted to see whether historically, fast growth of the monetary base has been associated with faster growth of real output.” Yi Wen reported that when the policy for reserve levels were increased, the banks reserve levels went up to a 300-fold increase of about $2.285 trillion as compared with $8 billion level inn September 2008. On a short term basis, Yi Wen reported that the monetary policy produced positive growth effects, but the positive growth dissipates on the long run due to inflation. Yi Wen concluded that a large monetary base is not an indication of growth. Chart at left shows the association of monetary base on GDP growth at different levels. The horizontal axis represents the number of quarters while the vertical axis indicates the estimated impact of the money growth on output growth. The solid lines is the estimation and the dashed lines are the standards Chart explains that in the first two quarters, is slightly negatively associated with GP growth, but in the later quarters, for a period of 2 to 4 years, money base have positive effect to GDP growth; but declines in the long run. (Yi Wen) The effect of monetary policy to employment, across country study. The employment sector is one of the sectors hurt most by economic policy particularly in times of recession. Studies have shown that the unemployment situation in the U.S. is not different from other countries affected by contraction monetary policy. The research done by Altavilla and Cicarelli (2008) on the “rule-based monetary policy on unemployment dynamics in the euro area and the U.S. showed evidence of a high degree of dispersion across models in both policy rule and impulse response.” The study found out that monetary policy creates similar recessionary effects on the two economies, and that differences are too small. In another country study in Swedish unemployment, study done by Alexius A, and Holmlund, B. in Uppsale University (2007) stated that’30 percent of fluctuations of unemployment in Sweden is caused by monetary policy, that there are persistent effects that even lasts to ten years. The interest rates and the effect of monetary policy Here is how the monetary policy affected the U.S. Perhaps everybody remembers the financial crisis that was due to loose credit policies, and the low interest rates Raising or lowering interest rates is one of the tools used by the Federal Reserve to implement its monetary policy. In either way, it affects the people’s and firms’ demand for goods and services. A change in interest rates alters borrowing costs, bank loans availability, the wealth of households and the foreign exchange rate. Consider the example, when the real interest rates goes down, the cost of borrowing also goes down. This is followed by an increase spending on investment, buying of durable goods by households, such as new homes and cars as have been the experience in the financial crisis. The low interest rates have been blamed for the cause of financial crisis. However, the IMF contradicts reports circulated that low interest rate is the cause of financial crisis. (DPA Earthtimes. 02 Sept. 2009) This report said that IMF holds the responsibility from the loose monetary policy of the Fed Reserve in credit lending and not low interest rates. The advice of IMF to the Fed Reserve is to tighten monetary control conditions to prevent a recurrence of same crisis 4. Explain how money is created. There are two ways in which money is created. Fist, it can be fabricated by printing of bills and minting of coins by the Central Bank and becomes money in circulation. But economists view money creation in different aspect. Mike Hewitt, (23 May 2007), editor of a website about the current fiat monetary system, said that money is not created from economic and government activity, but rather comes from banks operations. He illustrated the banking transactions that create money making interests. Money creation starts from savings deposit, lending part of it with corresponding interest rates, thereby providing money income to the bank and to the depositor. 5. Which combinations of monetary policy help you to best achieve a balance between economic growth, low inflation, and a reasonable rate of unemployment Decisions on monetary policy are difficult task for the Federal Reserve. It has to take into consideration possible effects to the macroeconomic factors such as growth, inflation and employment. There has to be an in depth study that requires historical data, facts and figures that will help policy makers arrive at a decision. I have no enough experience to come up with a right combination that will strike a balance of all the economic factors. But based on the studies I have reviewed, an upward movement of goods is a strong indicator that there is an increase in money income and money supply; and that it has gone up faster than the productive output of the country. An upward movement is a good indicator and a signal system for the CB to go slow on the supply of money. If it does not, the continuing increase of money supply will have an adverse effect in the economy. REFERENCES Alexius, A. and Holmlund, B. (July 2007) “Monetary Policy and Swedish Unemloyment fluctuations” Uppsala University. Retrieved 23 October 2009) http://ftp.iza.org/dp2933.pdf Altavilla, C., Cicarelli, M. (March 2007) “The Effects of Monetary Policy on Unemployment Dynamics under Model Uncertainty - Evidence from the US and the Euro Area” CES Working Paper Series No. 2575 Retrieved 23 October, 2009 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1357245 DPA (22 Sept. 2009) IMF: Low interest rates were not main causes of financial crisis. Business News. Earthtimes. Retrieved 20 October 2009 from http://www.earthtimes.org/articles/show/286741,imf-low-interest-rates-were- Mofatt, Mike. “Expansionary Policy vs. Contractionary Policy”. About.com.Economics. Retrieved 22 October 2009 Satterthwante, Shad/ (2008). “What is the Federal Reserve and what does it do?” The Economic ProfessorUniversity of Oklahoma .This Nation.com. Retrieved from Read More