Monetary Policy Impact on Macroeconomic
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There are 12 Federal Reserve Banks that make up the central bank in the United States of America. These 12 banks are also known as the Fed. The Fed has three tools of monetary policy they can use to control the money supply. They are open-market operations, the reserve ratio, and the discount rate. These three tools used by the Fed have an impact on gross domestic, product (GDP), inflation, interest rates, and unemployment.
Open-Market Operations
The Fed’s the most important tool is the open-market operations. The open-market operations deal with buying or selling government bonds to commercial banks or to the public. When the Fed buys bonds from commercial banks, the commercial bank will have negative securities and positive reserves in assets. The positive reserves will increase the lending ability of the commercial banks. The commercial bank will have positive reserves in assets and positive checkable deposits in liabilities and net worth, when the Fed buys bonds from the public. Buying bonds from the public is similar to buying bonds from commercial banks. They both increase the lending ability of the commercial banks.
The opposite will occur when the Fed sells government bonds to commercials banks. The commercial bank will have a positive for securities and a negative for reserves in assets. The negative reserve in assets will decrease the lending ability of the commercial banks. The Fed selling to the public will cause the same result as selling to commercial banks. The commercial banks will have negative reserves in assets and negative checkable deposits in liabilities and net worth. Commercial banks and the public are willing to buy or sell government bonds to the Fed depending on the price of bonds and their interest rates.
The Reserve Ratio
Another tool that the Fed uses to influence the lending abilities of commercial banks is the reserve ratio. The reserve ratio is a percentage of deposits that a bank holds as reserves. The Fed mandates a certain percentage of this ratio for commercials banks to hold in their reserves. Raising the reserve ratio can lead to a decrease in excess reserves and prevent lending abilities by commercial banks. If the Fed lowers the reserve ratio the opposite will occur, excess reserves will increase and commercial banks will be able to create money for lending.
The Discount Rate
Another tool the Fed uses is the discount rate. The discount rate is the interest rate that the Fed charges commercial banks for loans. Just as the commercial banks charge the public interest rates for borrowing money, the Fed will charge the commercial banks a discount rate for borrowing money. Borrowing funds from the Federal Reserve Bank by the commercial banks increases the reserves of the commercial banks and enhances their ability to extend credit (McConnell & Brue, 2004, p. 247). When the discount rate is increased, commercial banks will look to other commercial banks for loans and not the Federal Reserve Bank.
Affects on Macroeconomic
When the economy is facing recession or high unemployment the Fed must buy government bonds, lower the reserve ratio, or lower the discount rate. Excess reserves will increase causing the money supply to rise. Interest rates will fall causing investment spending to increase. The aggregate demand will increase causing real GDP to rise by a multiple of the increase in investment. These actions are called an easy money policy (McConnell & Brue, 2004, p. 275). When the economy is facing inflationary period the Fed must do the opposite of an easy money policy. The Fed must sell government bonds, increase reserve ratio, or increase the discount rate. Excess reserves will decrease causing the money supply to fall. Interest rates will increase causing investment spending to decrease. Aggregate demand will decrease causing inflation to decline. These actions are called a tight money policy (McConnell & Brue, 2004, p. 275).
Buying government bonds will release money into the system causing an increase in Real GDP. The increase to Real GDP will cause unemployment to decrease because work production will start rising due to investments and consumer demand. Investment will increase due to interest rate being low. The downside effect to releasing money into the system is an increase of inflation. Selling government bonds causes the opposite effect on Real GDP, unemployment, interest rates, and inflation. Selling government bonds takes money out of the system; therefore, Real GDP, interest rate and inflation will decrease while unemployment starts to increase.
Money Creation
Money can be created different ways in the commercial banks. The commercial banks primary way of creating money is through lending. When