Federal_Reserve_Paper

Federal Reserve Paper Introduction This paper will give definition to the purpose and function of money. It will explain how the Federal Reserve manages the monetary system of the United States. This paper will also outline the stated direction of recent monetary policy in this nation. It will list at least one policy action taken by the Federal Reserve confirming that direction. And, this paper will give explanation to the effects of monetary policies on production and employment within the economy. a. Define the purpose and function of money. In defining the purpose of money, one must simply define its functions. There are three functions of money. First of all, money is a medium of exchange. It is also a unit of account, and a store of value. “A medium of exchange is an item that buyers give to sellers when they purchase goods and services.” (Mankiw, 2007, p. 643) For example, when a person goes to Joe’s Diner for a hamburger and shake, he pays Joe with money for the meal he just ate. Money as a unit of account is a measurement used to understand the value of a good or service or a debt. For instance, if a Pepsi costs $1 and a television costs $200, the TV may be worth 200 Pepsis, but it is measured in dollars. Money as “a store of value is an item that people can use to transfer purchasing power from the present to the future.” (Mankiw, p. 643) When a person buys gasoline today, the store owner can hold that money to purchase a new putter next week. b. Explain how the central bank manages a nation’s monetary system. The Federal Reserve is the central bank of the United States. It was created in 1913 to supervise the nation’s banks and to regulate the money supply of the nation. The Fed manages the nation’s monetary system with the “three tools in its monetary toolbox: open-markets operations, reserve requirements, and the discount rate.” (Mankiw, 2007, p. 653) In open-market operations, the Fed buys or sells government bonds to either increase or decrease the money supply. When it buys government bonds, the money supply increases and is circulate within the economy. When the Fed sells these bonds, it decreases the money supply. Reserve requirements are used by the Fed to regulate the amount that banks can lend. If it raises the reserve rate, banks must hold more money in reserve. As a result, less money can be loaned out, which means less money is created and the money supply decreases. If the reserve rate is lowered, the opposite occurs. The third tool used by the Fed is the discount rate. Sometimes banks need to borrow money from the Fed for various reasons. The discount rate is the interest rate a bank pays on its loans from the Fed. “A higher discount rate discourages banks from borrowing reserves from the Fed.” (Mankiw, p. 654) This reduces the money supply. A lower discount rate has the reverse affect. c. Outline the stated direction of recent monetary policy in the U.S. I. Federal funds rate maintained between 0 and 0.25 percent. II. Purchased mortgage-backed securities and agency debt. III. Supplied funding to banks and markets. IV. Presented Financial Stability Plan. V. Introduced Term Asset-Backed Securities Loan Facility. IV. Increased purchases of mortgage-backed securities and agency debt. d. List at least one policy action that the Federal Reserve has taken to confirm that direction. The Federal Reserve, by increasing purchases of mortgage-backed securities and agency debt, confirms the stated direction of monetary policy. It has taken an expansionary stance by increasing the money supply, attempting to stimulate the economy. e. Explain the effects of monetary policies on the economy’s production and employment. Monetary policies have the following effects on production and employment within the economy. By manipulating the real interest rate, the demand for goods and services is affected as well as unemployment. When the real interest rate is lowered, borrowing money is more attractive, businesses will increase investment spending, and consumer will buy more durable goods like houses. In the short run, lower interest rates will reduce the dollar’s foreign-exchange value, which raises prices of U.S. exports. In turn, the price of products imported will rise, leading to an increase in aggregate demand in the U.S. Domestic firms increase production and employment. Conclusion In conclusion, this paper has defined the purpose and function of money. It has explained how the central bank, or Federal Reserve, regulates the monetary system with its various tools. This paper has also given an outline the stated direction of recent monetary policy taken by the Federal Reserve, and it has listed one policy action confirming that direction. And, finally, it has explained the effects of monetary policies on production and employment in the economy. Reference Mankiw, N. G. (2007). Principles of Economics (4th ed.). Mason, OH: Cengage Learning.