MAC - Monetary Policy Lesson
Monetary Policy
Money
The Federal Reserve controls the United States money supply. Money is anything that serves as a medium of exchange, a unit of account, and a store of value. In other words, money can be anything that is used to determine value during the exchange of goods and services, is a means for comparing the values of goods and services, and keeps its value if it is stored rather than used.
Money Creation
Through a process called money creation, the Federal Reserve controls the amount of money entering into circulation. Money creation does not refer to printing more money. Money is created whenever a bank loans out money. Let’s say you borrow $1000 from one bank. You deposit $1000 in your checking account. Now the bank will loan out part of the $1000 you deposited. Whatever amount of your money the bank loans out to someone else becomes new money for them. When they deposit this money, their bank will loan out a portion of it.
Monetary Policy Tools
The Federal Reserve controls this process by setting the required reserve ratio, which tells banks how much money they are required to keep and not loan out. If the Federal Reserve wishes to create more money, they can lower the required reserve ratio and let banks loan out more money. Raising the required reserve ratio forces banks to keep more money and loan out less; a higher required reserve ratio decreases the money supply.
The required reserve ratio is simply one tool the Fed uses to affect the money supply. They can also change the discount rate, or the interest rate the Fed charges on loans to banks. Typically, the Fed sets their discount rate above the federal funds rate, which is the interest rate banks charge each other, so banks borrow from one another. By changing the federal funds rate and the discount rate, the Fed affects the interest rates banks charge on loans to their best customers. Lower interest rates encourage borrowing and increase the money supply; higher interest rates discourage borrowing and decrease the money supply.
The final monetary policy tool is by far the most used. Through open market operations, the Fed buys and sells government bonds (securities). Buying more bonds increases the money supply as it puts more money into the banking system. Selling bonds decreases the money supply as banks have less money.
| What Monetary Policy Tools Increase/Decrease Money Supply? | ||
|---|---|---|
| Increase the money supply (easy money policy) | Decrease the money supply (tight money policy) | |
| Open Market Operations | Buy Bonds | Sell Bonds |
| Required Reserve Ratio or Discount Rate or Interest on Reserves | Decrease | Increase |
How Does Monetary Policy Stabilize the Economy?
During a contraction/recession, unemployment is rising. The Federal Reserve chooses to increase the money supply to lower interest rates and stimulate spending to achieve full employment. This action is known as easy money policy.
During an expansion/recovery, inflation is occurring. The Federal Reserve chooses to decrease the money supply and increase interest rates to keep prices stable. This action is known as tight money policy.
Ask Yourself
- What is the phase/problem?
- Expansion/Inflation
- Contraction/Unemployment
- What does the Fed do to the money supply?
- Decrease
- Increase
- What happens to interest rates?
- Increase
- Decrease
Monetary Policy Practice and Vocabulary Review
IMAGES CREATED BY GAVS OR FOUND IN THE PUBLIC DOMAIN