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Originally Published: 3/22/2006


By The Issue Wonk



The U.S. government manages the overall economic activity of the country through its Monetary and Fiscal Policies. The goal of Monetary Policy is “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” (The Federal Reserve Act, Section 2A)


Monetary policy refers to the actions of government in which it controls, directly or indirectly, the nation’s money supply and interest rates. The nation’s “money” involves currency, bank deposits, and financial assets. The ultimate targets of monetary policy are maximum employment, stable prices, and moderate long-term interest rates. Monetary policy is administered by the Federal Reserve System, known commonly as “The Fed.” The Fed has three (3) main tools for maintaining control over the supply of money and credit in the economy: the Open Market Operations (buying and selling government securities), controlling the money supply, and controlling the interest rate.


Open Market Operations.  In order to increase the supply of money, the Fed buys government securities from banks, businesses, or individuals with a check that is a new source of money that it prints. That money is deposited in banks where they create new reserves. The banks can lend or invest that money, thereby increasing the amount of money in circulation. On the other hand, if the Fed wishes to reduce the money supply, it sells government securities to banks, collecting the reserves from them and thus taking that money out of circulation.


Controlling the Money Supply.  The Fed can control the money supply by specifying how much of the banks’ reserves must be set aside either as currency in their vaults or as deposits at their regional Reserve Banks. The remainder can be loaned out.  Raising the required reserves leaves less money to be loaned and forces the banks to take money out of circulation. Conversely, lowering the required reserves allows more loans to be made and, therefore, puts more money in circulation. Also, since banks often lend each other money overnight, the rate on these loans, known as the “federal funds rate,” is a key gauge of how “tight” or “loose” monetary policy is at a given moment.


The Discount Rate.  This is the interest rate that commercial banks pay to borrow funds from the Fed. The interest rate at which banks borrow from the Fed helps to determine the interest rate that they charge for the loans they make to consumers. By raising or lowering the discount rate, the Fed can promote or discourage borrowing and thus alter the amount of revenue available to banks for making loans.


These tools allow the Fed to expand or contract the amount of money and credit in the economy. If the money supply rises, credit is said to be loose. In this situation, interest rates tend to drop, business and consumer spending tends to rise, and employment increases. If the economy is already operating near its full capacity, too much money can lead to inflation, or a decline in the value of the dollar. When the money supply contracts, credit is tight. In this situation, interest rates tend to rise, spending levels off or declines, and inflation abates. If the economy is operating below its capacity, tight money can lead to rising unemployment.


There are factors, however, complicate the ability of the Fed to use monetary policy to control the economy. Money can be held in different forms (paper money, checking deposits, money market accounts, etc.) and the amount held in the various forms can change from time to time, depending on factors that may or may not have an effect on the economy.



© The Issue Wonk 2006



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