Monetary policy has become the dominant component of the United Stated stabilization policy because it is faster and more flexible than fiscal policy; as well monetary policy is isolated from political pressure. The Federal Reserve has three primary monetary tools by which it can influence the money creating abilities of the commercial banking system; open market operations, reserve ratio and discount rate (Federal Reserve Bank of New York, 2007).
An open market operation consists of the buying and selling of government bonds to both commercial banks and the public. This process of buying and selling securities is the Federal Reserve’s most effective way of influencing the money supply. Whether the Federal Reserve decides to buy government bonds from commercial banks or the public, the reserves of commercial banks will increase.
When the Federal Reserve buys bonds from commercial banks the bank gives up part of their bonds to the Federal Reserve banks and in paying for those bonds the reserves of the commercial bank will increase. The most important thing about this transaction is by increasing the reserves in the banking system the lending ability of commercial banks will also increase. Although the effect of purchasing bonds from the public is similar to that of purchasing bonds from commercial banks the process is different. The transaction begins with the individual or company giving their bonds to the Federal Reserve Banks where they will receive a check drawn directly from the Federal Reserve Banks. The individual will then deposit the check into their commercial bank account. Once deposited the commercial bank will send the check to the Federal Reserve for collection; in turn increasing the commercial banks reserves. In the open market, commercial banks’ reserves are increased when Federal Reserve Banks buy securities.
On the contrary, when Federal Reserve Banks sell government bonds the reserves of commercial banks are reduced. In the open market Federal Reserve Banks give up bonds to commercial banks; which are paid for by drawing checks against the banks’ deposits. The Federal Reserve then collects the funds by reducing the commercial banks’ reserves. When the Federal Reserve Banks sell bonds to the public the individual or company pays with a check drawn from the commercial bank. The check is then drawn off of the commercial banks’ reserves and the checkable deposit of the individual is reduced. As the Federal Reserve Banks sell government bonds in the open market, commercial bank reserves are reduced.
The second way the Federal Reserve attempts to control the money supply is through manipulating the reserve ratio; which is the percentage of commercial bank deposit liabilities required as reserves. Change in the reserve ratio affects the money creating ability of the banking system by changing the amount of excess reserves and changing the size of the monetary multiplier. Raising the reserve ratio causes the commercial banks to reduce checkable deposits. While lowering the reserve ratio transforms required reserves into excess reserves; enhancing the commercial banks’ ability to create new money. Although manipulating the reserve ratio is a powerful tool in monetary control it is not used very often.
Lastly, when a commercial bank is forced to draw a short term loan from the Federal Reserve it gives the Federal Reserve a promissory note drawn against its self and secured by government bonds. The Federal Reserve will in turn charge the commercial bank interest on the loan. The interest charged is called the discount rate. The ability of commercial banks to make loans from the Federal Reserve Banks increases the reserves of the commercial bank enhancing the bank’s ability to extend credit to their customers. As the Federal Reserve lowers the discount rate the money supply increases and as the discount rate increase the money supply is reduced.
The money supply consists of currency and checkable deposits. Money is created via three different avenues; the Federal Reserve and banking system, single commercial banks and the banking system (multiple deposit expansion). The United States has a fractional reserve banking system in which only a fraction of the total money supply is held in reserve as currency. The fractional reserve banking system has two defining characteristics.
The first characteristic of the fractional reserve banking system is money creation and reserves. In today’s economy banks can create money (checkable deposits) through lending. The amount of checkable deposits created is limited by the amount of currency reserves the bank is required by law to keep. Secondly, banks that operate using fractional reserves can be vulnerable to panics. A panic occurs when the majority of people who deposited money into a bank all demand their money at the same time. In this circumstance the bank would be ruined as it has issued more checkable deposits than the amount of currency available. Fortunately, a bank panic is unlikely as long as the banker’s reserve and lending policies are prudent.
Single commercial banks create money by granting loans, repaying loans and buying government securities. When a bank grants a loan it creates money. An individual can walk into the bank with nothing and walk out with a checkable deposit (money). A large amount of the money in our economy today is created via commercial banks by the extension of credit. When a loan is repaid the supply of money is reduced, the amount of checkable deposits destroyed. The decrease in checkable deposits lowers the bank’s required reserves in turn providing excess reserves creating the basis for new making new loans. The third and final way a commercial bank makes money is by purchasing government securities. When a bank buys government bonds from the public money is created. Purchasing government bonds from the public creates money in the same way as lending to the public does. Banks accept government bonds (not money) and give the securities dealers an increase in its checkable deposits (money) (Robert J. Gordon, 2007).
The commercial banking system can lend (can create money) by a multiple of its excess reserves making it different from single commercial banks which can only lend dollar for dollar from their reserves. The banking system uses a monetary multiplier to magnify excess reserves into a larger checkable deposit. The monetary multiplier exists because the reserves and deposits lost by one bank become reserves of another bank. It magnifies excess reserves into a larger creation of checkable-deposit money (Schoen, 2007).
The Federal Reserve uses varying monetary policies to help the economy achieve price stability, full employment, and economic growth. Monetary policy operates through a complex cause-effect chain. Policy decisions affect commercial bank reserves; changes in reserves affect the money supply; changes in the money supply alter the interest rate; changes in the interest rate affect investment; changes in investment affect aggregate demand; changes in aggregate demand affect the equilibrium real GDP and the price level (Robert J. Gordon, 2007).
The easy money policy (or expansionary monetary policy) occurs when the Federal Reserve buys government bonds in an open market and lowers both the reserve ration and the discount rate (Robert J. Gordon, 2007). The purpose of the easy money policy is to make bank loans less expensive and more available and thereby increase aggregate demand, output, and employment. The steps of the easy money policy when applied during a recession and time of increased unemployment are 1) Federal Reserve buys bonds, lowers the reserve ratio or discount rate, 2) excess reserves increase, 3) money supply rises, 4) interest rates fall, 5) investment spending increases, 6) aggregate demand increases, 7) real GDP rises (Robert J. Gordon, 2007).
Tight money policy (or restrictive monetary policy) occurs when the Federal Reserve sells government bonds and increases both the reserve ratio and the discount rate. The goal of the tight money policy is to limit the amount of money to reduce spending and control inflation. The steps of the tight money policy applied during a time of inflation are 1) Federal Reserve sells bonds, increase the reserve ratio or discount rate, 2) excess reserves decrease, 3) money supply falls, 4) interest rates rise, 5) investment spending decreases, 6) aggregate demand decrease, 7) inflation decreases (Robert J. Gordon, 2007).
Monetary policy faces complications and problems such as lags, changes in velocity and cyclical asymmetry. Lags occur because once the Federal Reserve acts it can take three to six months for interest-rate changes to have their full impacts on investment, aggregate demand, real GDP, and the price level. The velocity of money may increase or decrease during the time the Federal Reserve is trying to increase or decrease the money supply frustrating monetary policy. Cyclical asymmetry occurs when monetary policy is effective at controlling inflation but less effective when pushing the economy out of recession (Robert J. Gordon, 2007).
It is possible that the Federal Reserve can create and control the flow of money in the United States by buying and selling government bonds to commercial banks as well as to the general public; adjusting the reserve ratio and the discount rate. Although monetary policy has its weaknesses, as time lags, the possibility that changes in velocity will offset it and potential ineffectiveness during a severe recession becomes its strength. The Federal Reserve has flexibility, speed and political acceptability that make it the dominant choice for policy stabilization in the United States today.
Federal Reserve Bank of New York (2007). Tools of Monetary Policy-You and the Fed-Economic Education. Retrieved April 2, 2009 from Federal Reserve System Web site: http://www.newyorkfed.org/education/fed/tools.html
Schoen, John (2007). How does Fed ‘inject’ Money into the System?. Retrieved April 5, 2009 from MSNBC Web site: http://www.msnbc.msn.com/id/20218020/
Peter Coy , “Macroeconomics: Adjusting the Big Picture.” Business Week APRIL 16, 2009 Web.21 April 2009. http://www.businessweek.com/magazine/content/09_17/b4128030003762.htm.
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