Monetary Policy and Its Impact on the Recession

Running head: MONETARY POLICY/MACROECONOMIC IMPACT PAPER

Monetary Policy/Macroeconomic Impact Paper
Heather Robinson
University of Phoenix
MMPBL 501
04/25/2010

Introduction The Federal Reserve Board (FED) utilizes tools to control or manipulate the money supply, these tools affect macroeconomic factors such as inflation, unemployment and interest rates, which ultimately determine a country’s GDP. To recommend the best monetary policy combination I will discuss the tools used by the feds, explain how money is created and also illustrate the effect of the money supply on the economy. It is the money supply which determines the rate of inflation, unemployment and economic growth.

Tools Used by The Federal Reserve To Control Money Supply. The Fed has three main tools for controlling the money supply these are their Open Market Operations, The Discount Rate, and The Reserve Ratio. These tools can be used to alter the reserve ratios of the commercial banks which in turn determine the money supply. “The money supply consists of currency (Federal Reserve Notes and coins) and checkable deposits. The U.S. Burea of Engraving creates Federal Reserve notes and the U.S. Mint creates the coins.”(McConnell & Brue 2004) “By purchasing government bonds, (securities) the Fed increases the reserves of the banking system which then increase the lending ability of the commercial bank,”(McConnell & Brue 2004) and the money supply available. Selling bonds will also achieve the opposite results namely reduce the money supply by reducing the reserves of the bank. The central bank desires to be a lender of last resort. When the commercial bank borrows it gives the Fed a promissory note drawn against itself and secured by acceptable collateral. The Fed charges interest on the loans which is called the discount rate. The new reserve obtained by borrowing from the Fed immediately becomes excess reserves as no required reserve needs to be kept for loans received from the Fed. Thus by reducing the discount rate, commercial banks can be encouraged to borrow from the Fed which directly increases their excess reserves and their ability to lend, so the money supply is increased. The opposite can also be done to reduce the money supply. The Fed can also manipulate the reserve ratio as a means of affecting the ability of commercial banks to lend. If the Fed increases the reserve ratio the commercial bank is forced to reduce its checkable deposits in order to increase its reserves to the new minimum requirement. It might also be forced to sell some bonds in order to increase its required reserves, and both scenarios would result in a reduction of the money supply. By lowering the reserve ratio the commercial banks reserve is transformed into excess reserve which increases the banks capability of lending, which increases the money supply. “Interest rates in general rise and fall with the federal funds rate. The prime interest rate is the benchmark rate that banks use as a reference point for a wide range of interest rates on loans to business and individuals.” (McConnell & Brue 2004) Therefore when the Fed changes the discount rate it also changes the prime interest rate. A lower discount rate is passed on to consumers who then are able to obtain lower interest rates for mortgages and credit cards which increases their disposable income. This higher disposable income then results in more demand for goods and services which causes an increase in the supply of these goods to meet the increasing demand. Also an increase in the money supply and more money to lend by the banks result in more credit for businesses who are then able to purchase more materials to produce more or invest into the expansion of their businesses. The end result is that more goods and services are being produced as a result of the increase in money supply, which is beneficial to the country’s GDP. “In brief, the impact of changing interest rates is mainly on investment (and, through that, on aggregate demand, output, employment and the price level). Moreover investment spending varies inversely with the interest rate.”(McConnell & Brue 2004) The Creation of Money Money creation occurs in two main ways, the creation of base money, mostly currency notes created by the Federal Reserve. The second process involves checking account or deposit money created by commercial banks, which makes up most of the money supply. Base money is created when the Fed performs open market operations. The Fed injects money when it purchases Government securities, by creating it. Almost all money we come by has its basis in money that the Fed invented Once this money has been created approximately ten times as much can be created by banks in checking accounts and deposits. They accomplish this by granting loans to the public, a corresponding amount of checking account money is created with each new loan. So money is created when the money supply is increased. Using expansionary monetary policy, decreasing the reserve ratio and discount rates, or buying bonds and securities result in money being created.

State of the Economy With regards to the U.S. economy, it has “contracted further since the beginning of the recession, and the labor market worsened over the first half of 2009”. according to the published monetary policy report to the congress. (MPRC July 2009) Economic activity decreased sharply and strains in financial markets and pressures on financial institutions overall intensified. (MRPC July 2009.) However the negative activity appears to be abating, unemployment has continued to increase but at a slower pace, while inflation has been minimal. To date the credit conditions continue to be restrictive and it is still difficult for businesses and households to receive credit. The U.S. real gross domestic product (GDP) was less than the first quarter of 2009, though it seems that the” contraction of overall output looks to have moderated somewhat of late. “(MPRC July 2009). Consumer spending was increased due to the tax cuts and increases in various benefit payments received as part of a stimulus package, which increased disposable incomes. The housing market has experienced some stabilization in the demand for new houses after three years of persistent declines. Businesses however have continued to decrease their capital spending and liquidating of inventories due to reduced demand and excessive stocks. More recently foreign demand has also dropped for U.S. products which produced a reduction in U.S. exports and the U.S. demand for imports also fell.

Concerns of the Federal Reserve and Directions of Recent Monetary Policy The Federal Reserve policy action has focused on facilitating economic recovery and encouraging the flow of credit, which brought the federal funds rate down to a historic low rate of zero to one quarter percent, and also purchased additional agency (MBS) mortgage backed securities. (MPRC 2009) “Overall consumer price inflation which slowed sharply late last year remained subdued in the first half of this year, as the margin of slack in labor and product markets widened considerably further as prices of oil and other commodities retraced only a part of their earlier steep declines.”(MPRC2009)There is no effort to control inflation which seems to be under control so all emphasis is been placed on assisting the economy in recovering from the recession using monetary policies. In addition to reducing the federal funds rate and purchasing securities, the Fed continued to provide funding to financial institutions and markets using a variety of credit and liquidity facilities. Recent monetary policy actions include the decision of the Federal Open market Committee (FOMC), to expand its purchases of agency MBS and agency debt and to commence the purchasing of longer-term treasury securities to assist in improving the conditions in private credit markets. The fed also announced it will expand the eligible collateral under the TALF program, which is the recently launched Term Asset-Backed Securities Loan Facility. In June 2009, at the FOMC meeting, the members of the Board of Governors of the Federal Reserve System and presidents of the Federal Reserve Banks provided projections for economic growth, unemployment and inflation, these projections included the expectation of “real GDP to bottom out in the second half of this year, and then move onto a path of gradual recovery, bolstered by an accommodative monetary policy, government efforts to stabilize financial markets, and fiscal stimulus.” (MPRC2009) It was also projected that conditions in the labor market would continue to deteriorate, and then improve slowly over the next two years, and inflation would remain subdued in 2010 and 2011.

Recommended Monetary policy When trying to recover from a recession and stimulating economic growth it is possible to increase inflation due to the increase in money supply if the expansionary policies are prolonged. There has to be a balance which will reduce unemployment, deter inflation and yet promote economic growth. Monetary policy has been the best choice to manipulate the money supply as it is flexible, prompt and isolated from political pressure. (McConnell & Brue 2004) The Fed can utilize open market operations, discount rate and the reserve ratio to achieve a balance between inflation, economic growth and unemployment. If the expansionary monetary policies result in too much spending and increased inflation, it can be curbed by selling securities, or increasing the discount rate and reserve ratios of the commercial banks. In the University of Phoenix simulation, the scenarios represented opportunities to utilize monetary policies to curb inflation, unemployment and increase GDP. The solution was the effective manipulation of the discount rate, reserve ratio, and open market operations. What was noticeable was that when the money supply increased so did inflation, and the unemployment rate is inversely related to the GDP. When the GDP increased unemployment fell. Conclusion The three tools of monetary policy which include, open market operations, the discount rate and the reserve ratio are quite effective in the application of expansionary or restrictive monetary policies to combat recessions or curb inflation. Whenever the Fed lowers the discount rate or the reserve ratio they increase commercial banks lending which stimulates aggregate demand and investment. The most effective tool seems to be the open market operation which is utilized more frequently, as the Government buys and sells securities often to manipulate the commercial bank’s reserves. Monetary policy is most effective due to speed and flexibility, it is free from political pressure and can be quickly utilized to respond to inflation and unemployment, and to create economic growth.

References
Bankers Research Institute, The Wizards of Money Part 1: How Money Is created. Retrieved April 26, 2010 from http://www.altruists.org/static/files
McConnell, C. & Brue, S. (2004). Economics: Principles, Problems, and Policies, 6th ed. McGraw-Hill Irwin.
Monetary Policy Report to the Congress, July 21, 2009. Retrieved April 26, 2010 from http://www.federalreserve.gov/monetarypolicy/mpr_20090721_part1.htm
University of Phoenix. (2010). Simulations Monetary Policy [Computer Software]. Retrieved from University of Phoenix, Simulation MMPBL 501 website.

References: Bankers Research Institute, The Wizards of Money Part 1: How Money Is created. Retrieved April 26, 2010 from http://www.altruists.org/static/files McConnell, C. & Brue, S. (2004). Economics: Principles, Problems, and Policies, 6th ed. McGraw-Hill Irwin. Monetary Policy Report to the Congress, July 21, 2009. Retrieved April 26, 2010 from http://www.federalreserve.gov/monetarypolicy/mpr_20090721_part1.htm University of Phoenix. (2010). Simulations Monetary Policy [Computer Software]. Retrieved from University of Phoenix, Simulation MMPBL 501 website.