Federal_Reserve_Monetary_Policy

Federal Reserve Monetary Policy University of Phoenix 31 July 2009 Federal Reserve Monetary Policy Money is accepted for payment or transfer of wealth from one person to another in trade for goods and services. Money has three functions in an economy; medium of exchange, a unit of account, and store value. These functions collectively separate money from other assets in the economy, such as stocks, bonds, real estate, and even baseball cards (Mankiw, 2007). A medium of exchange is an item received for goods and services from buyer to seller. What should a medium of exchange possess' It should be transportable and divisible, have high market value in relation to volume and weight, and be recognizable and resistant to counterfeiting. A person should feel certain the seller will acknowledge their money for the item the business is selling because money is a generally acknowledged for medium of trade. As money flows from person to person in the economy, it facilitates production and trade, thereby allowing each person to specialize in what he or she does best and raises everyone’s standard of living (Mankiw, 2007). A unit of account is a standard of measurement on how the market values goods, services, or assets. If a person borrows money from a bank, the amount of the loan repayment will be measured in dollars, not in an amount of goods and services. When economic value is recorded, the bank measures the use of money as the unit of account. A store of value is an asset, money or other type of capital that is tradable and can be stored and retrieved over time. A store of value is the basic component of the economic system because it allows individuals to trade goods and services. When a seller accepts money for goods or services, the seller can store the money and become the buyer sometime in the future. The term wealth is used to refer to the total of all stores of value, including both money and nonmonetary assets (Mankiw, 2007). The central bank for the United States is the Federal Reserve Bank (the Fed) which manages our nation’s banking systems and regulates the amount of money in circulation by setting monetary policies. The Fed attempts to balance the economy by keeping prices steady, workers employed and manufacturers producing goods in three ways: open market operations; discount rate, and the regulation of the amount of reserves that banks must maintain on hand. The Federal Open Market Committee (FOMC) meets every six weeks to review the economic conditions of the open mark operation to see how loose or tight they want monetary policy. The FOMC has the power to create money out of nothing by purchasing and selling US government bonds on the open market. If the FOMC decides to increase the money supply, the Fed creates dollars and uses them to buy government bonds from the public in the nation’s bond markets (Mankiw, 2007). If the Fed wants to decrease amount of money in circulation they sell government bonds in the open market, tightening credit conditions. The economy is affected by the Federal Reserve Bank’s increase and decrease in the amount of money in circulation. The discount rate is the interest rate the Fed charges on loans made to banks. To encourage or discourage banks to borrow money, the Fed increases or decreases the rate, changing the amount of money in circulation. When the discount rate is decreased, banks are encouraged to make loans to consumers. This encourages people to borrow money from the banks at lower interest rate creating a surplus of money in the economy. The reserve requirement is the amount of funds a bank must hold in reserve against deposits rather than loaning it out; the Federal Reserve Bank holds these funds. The amount of reserve funds the Federal Reserve Bank holds depends on the bank’s liabilities. If a bank does not have enough reserve funds, it has to cut back on lending money until they meet the requirement. These three monetary tools help the Federal Reserve Bank determine its monetary policy. As the US economy tries to stay alive, the monetary policy is to stimulate the economy so people can retain their jobs and unemployment does not rise, while at the same time battling inflation by having a tighter monetary policy that will promote price stability and economic growth. The first method in tightening is to raise rate of interest being paid on banks’ reserve balances and increasing the federal funds rate and other short-term market interest rates. This method prevents draining the reserve balances. The second method in tightening the monetary policy is to decrease the overall level of reserve balances. The Federal Reserve Bank has a number of options for decreasing the level of reserve balances if such action is needed. The first option establishes repurchase agreements with financial market participants. The second option is that the treasury could sell more bills and deposit the proceeds with the Federal Reserve (Monetary Policy, 2009, page 36). The treasury has been using this method since late 2008; deposits are shown on the balance sheet as Supplementary Financing Account. The third option would give banks the opportunity to have interest paid on term deposits while the Federal Reserve Bank holds some of the money. All three of these options could be used to tighten monetary policy by draining reserve balances and rising short-term interest rates (Monetary Policy, 2009, page 36). How has the current monetary policy affected the economy’s production and employment' Even though the current monetary policy is trying to stimulate the growth of the economy, the unemployment rate is rising. Many businesses are cutting back on jobs and labor by going to a shorter workweek. The new emergency unemployment insurance program encourages people to continue looking for work and stay in the work force. However, production has continued to increase at a surprising rate during the most recent downturn, in part because businesses have responded to the contraction in aggregate demand by aggressively reducing employment and shortening the workweeks of their employees (Monetary Policy, 2009, page 16). References Mankiw, G (2007) Principles of Economics (4th ed.) Thomson South Western Corporation Monetary Policy Report 21 July 2009 Retrieved July 29, 2009, from http://www.federalreserve.gov