Market Interaction in Collective Perspective - Essay Example

Monetary policy, in the broadest sense, includes all the tools enforced by the government to control the quantity of money in the economy. The quantity of money or the supply of money then affects the overall price level, exchange and interest rates, unemployment rate, and level of output. According to the Case and Fair (2007), U.S. monetary policy is formally set by the Federal Open Market Committee (FOMC), which sets goals concerning the money supply and interest rates as it directs the Open Market Desk in the New York Federal Reserve Bank to buy and/or sell government securities or debt and equity instruments. The capital market then is a market for securities where the government can raise long-term funds to finance its own projects usually regulated by the U.S. Securities and Exchange Commission (SEC) to protect investors mainly against fraud.

To give a quick summary of how money supply directly affects output or income, assume that there is an excess supply of money in the market. This will lead households, firms and buy bonds with their extra money so that it earns interest. This however will put downward pressure on the interest rate because many people will be investing their money in interest-earning instruments. Investors, on the other hand, borrow money from the banks with the very same interest rate that households and firms determine. A low-interest rate means more incentive for investors to borrow and put up their own businesses using their low-interest borrowings from banks. This, in conclusion, increases output and, in the long run, stimulates output growth.

According to Mankiw (2007), in recent years, the Fed has used the federal funds rate as its short-term policy instrument and when the FOMC meets every six weeks to set its monetary policy, it votes on a target for its interest rate and then directs the Fed Bond traders in New York to conduct open-market operations, the most important and most effective out of the three instruments of monetary policies by the government, necessary to hit that target. Because of this, in reality, and customarily, Fed policy is often discussed in terms of changing interest rates instead of changing the money supply. However, it is important to keep in mind that behind the changes in interest rates are the necessary changes in money supply as well (Mankiw, 2007).

A more in-depth look in the mechanisms of the Fed will show that the Fed controls the money supply indirectly by adjusting either the monetary base, the total amount of money held by the public as currency and by the banks as reserves, or the reserve-deposit ratio, the fraction of deposits that banks hold in reserves, usually determined by the Fed (Mankiw, 2007). The Fed then has three instruments of monetary policy: open-market operations, reserve requirements, and the discount rate.

As mentioned earlier, open-market operations are the buying and selling of government bonds or securities by the Fed, thus when the Fed buys bonds from the public, the dollars it pays for the bonds increase the monetary base and thereby increase the money supply. Reserve requirements, otherwise known as the Federal Reserve rate, are Fed regulations that enact a minimum reserve-deposit ratio which requires a certain percentage of the total money deposited in a bank to be held in the Federal Reserve Banks. An increase in the Federal Reserve rate raises the reserve-deposit ratio thereby lowering the money supply. The discount rate is the interest rate that the Fed charges when it makes loans to banks and thus the lower the discount rate, the cheaper are borrowed reserves thereby raising the monetary supply.

A required reserve ratio adjustment to change money supply is summarized by the formula, money multiplier equals 1/required reserve ratio. For example, given a monetary base of $100 billion, a required reserve ratio of 20 percent can support $500 billion in deposits. Following the formula, 1/.20 = 5, then multiplying 5 by the original $100 billion monetary bases, equals $500 billion. Money supply will then become $600 billion, $100 billion in currency, and $500 billion in deposits in banks.

All in all, it only seems logical that when there is low production and employment, an expansionary monetary policy is appropriate and when there is high production and employment to the point of having high inflation, then contractionary monetary policy is appropriate. Read More