The Impact Of The Monetary Policy On The Economy

The objective of monetary policy is to influence the performance of the economy as reflected in such factors as inflation, economic growth, and unemployment. It works by affecting demand of people and firms to spend on goods and services across the economy. Replying to the assignment questions will give a brief description on how some of these tools work to help stabilizing the economy

a) Identify tools used by the Federal Reserve to control money supply. How do these tools influence the Money supply?

The tools used by the Federal Reserve to control the money supply are interest rate, Required Reserve Ratio, and Open Market operation.

Interest rates have two components. The first one is the Fed Rate which is the interest rate that would be decided by the Fed Reserve on loans between banks over night. The second component is the Discount Rate that the Fed would apply to loans by commercial banks. Discount rate has an impact on money supply in the market; for example "A lowering of the discount rate encourages commercial banks to obtain additional reserves by borrowing from Federal Reserve Banks. When the commercial banks lend new reserves, the money supply increases" (Brue & McConnell, 2004, pg 275). Banks will shift their source of borrowing from other banks to the Federal banks if the Fed Discount Rate (DR) is lower than the FFR of the other banks. The spread between DR and FFR will increase as the DR increased. This will cause an increase of total amount of money in the system. The people in firms will be encouraged, borrowing money and their spending will increase. If DR of the Federal increased above FFR the banks will continue to borrow from other banks which will then restrict the money supply. The interest rate will increase, borrowing money will decrease, peoples spending will decline, and inventory of firms will increase.

The Required Reserve Ratio which is the mandate ratio or percentage of deposited or reserve that the bank hold with the Fed. When the ratio decreased the banks are required a lesser amount of reserves so that they are able to lend that extra money to their customers to increase the money supply in the market such as recession time. "In Short, borrowing from the Federal Reserve Banks by commercial banks increases the reserves of the commercial banks and enhances their ability to extend credit" (Brue & McConnell, 2004, pg 274). On the other hand, if the RR Ratio increased, the reserve percentage will increase, which will cause the money supply to decrease to balance the market spending as well as reduce inflation. The banks ability to lend money will decrease which will results in less money supply in the market.

Last is Open Market Operation, which is Federal securities that are sold or bought through the banks to the investors such as T-bills, stocks, and bonds. " First, as with Federal Reserve purchases of securities directly from commercial banks, the purchases of the securities from the public increases the lending ability of the commercial banking system" (Brue & McConnell, 2004, pg 271). The money supply in the market will increase. To decrease the money in the market the banks will sell these securities and the commercial bank reserves will be decreased.

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