The extremely large number of money exchanges that occurs each day all over the world form a highly complex web that is very resistant to analysis. However, it must be understood that the basis rules of money creation that govern these exchanges are readily understood and very simple. How money works is a little complex, however the effects it has on the macroeconomics factors such as GDP, unemployment, inflation, and interest rates can become very complex indeed. This paper will discuss monetary policy and its effect on macroeconomic factors such as GDP, unemployment, inflation, and interest rates.
The paper will also explain how money is created. Ultimately, the goal of this paper is to which combination of monetary policy will help best achieve a balance between economic growth, low inflation, and a reasonable rate of unemployment. Monetary policy affects many financial and economic decisions people make in our country. The Federal Reserve System conducts monetary policy and it influences demand by raising and lowering interest rates. The Federal Reserve was established so that a central bank would stabilize the economy and banking system.
The purpose of the monetary policy is to anipulate the performance of the economy in such factors as unemployment, inflation, interest rates, and GDP. The monetary policy works by affecting demand across the United States. There is lower unemployment and higher GDP when money is released into the system, but inflation is also raised. Real GDP and inflation work at cross-purposes and if the right balance is strike, they both can be very critical. When you compound this with the domestic policies, your macro-economic system can be unpredictable. The actual process of money creation takes place in banks.
Money is created by central banks like the Federal Reserve Bank in the United States. “The Original Constitution for the United States stated that Congress was to mint the money and set the value of the money in the United States” (, April 1, 2011). The Federal Reserve Bank is very secretive so it’s not really known exactly who the shareholders and owning banks are. Essentially the Federal Reserve simultaneously creates an asset and liability of the same amount with a private bank. The net sum is zero. This money is “deposited” in the bank’s Federal Reserve account.
The private bank can then use this money as a reserve through which they can lend out additional money to the public. This reserve rate is generally 10%. Thus, a “deposit” of the US Fed of $10,000 will transform into the private bank being able to loan out $90,000. (Hewitt, Sun, Nov 12, 2006). When loans are made, commercial banks create the money. Commercial banks are required to keep reserves on deposit in a Federal Reserve Bank. Monetary policy in the United States is based on unemployment, interest rates, inflation, and gross domestic product (GDP).
Lending institutions and or banks create money by lending money. More money is created when interest rates are lower. Banks borrow from the Federal Reserve and from each other. It is surprising to know that our money is not created by the government but by private banks. The factors that influence this are based on GDP. Unemployment falls and income increases as demand increases for products and services. Both the employee and the company’s income increases. To keep up with the increase in demand, companies will borrow from banks to improve their business.
Unemployment will decrease as companies expand and this would put money into the system and it will also provide more jobs for people. As long as people are employed, they will go out to dinner more and borrow money for housing and cars. These activities are a guarantee to put more money into the economy. The Federal Reserve cannot control employment, inflation or influence output directly, it affects them indirectly by lowering or raising a short-term interest rate. It does this through the federal funds market, which is an open market operation in the market for bank reserves.
Banks have to keep a certain amount of money in reserve to meet unexpected outflows. They are also required to keep a certain amount of funds in reserves, but they keep more funds than required because they have to restock ATM machines and clear overnight checks. Feds can regulate inflation, growth and unemployment through money supply. The interest rates are the tools that will change the amount of money available in the economic system. Monetary policy is seen to play a key role in the health of the US economy, having a direct impact on interest rates, employment, and inflation.
The media give prominent coverage to the statements and speeches by Federal Reserve officials because everyone knows that the Fed can send interest rates tumbling as it attempt to keep the economy on the path to non-inflationary growth. Wall Street reacts almost daily to any sign that worsening inflation might cause the Fed to tighten, or that a weaker economy might convince the Fed to ease. This acknowledgment of the importance of monetary policy is relatively recent and arose largely from the failures of monetary policy rather than its successes.
The Fed would have to slow money growth by raising interest rates; this would be the only way to win the war against inflation. This appears to be the only way to decrease inflation by slowing the economy down, and then the interest rates will fall. In conclusion, you would have to increase interest rates first to bring down inflation and by doing that, you will achieve the lowest interest rates. The Fed maintained that it did not have any specific target for interest rates, and that interest rates could fall only as the result of successful control of inflation over several years.
After reaching record high levels in the early years of the new policy, interest rates did retreat to lower levels. The goals of the monetary policy are very simple: When we think of the goals of monetary policy, we naturally think of standards of macroeconomic performance that seem desirable—a low unemployment rate, a stable price level, and economic growth. It thus seems reasonable to conclude that the goals of monetary policy should include the maintenance of full employment, the avoidance of inflation or deflation, and the promotion of economic growth.
But these goals, each of which is desirable in itself, may conflict with one another. A monetary policy that helps to close a recessionary gap and thus promotes full employment may accelerate inflation. A monetary policy that seeks to reduce inflation may increase unemployment and weaken economic growth. You might expect that in such cases, monetary authorities would receive guidance from legislation spelling out goals for the Fed to pursue and specifying what to do when achieving one goal means not achieving another. But as we shall see, that kind of guidance does not exist (, April 8, 2008).
The goals of monetary policy, some things that may come to mind would be standards of macroeconomic performance like a low unemployment rate, economic growth and or stable pricing. It thus seems reasonable to conclude that the goals of monetary policy should include the maintenance of full employment, the promotion of economic growth, and the avoidance of inflation. It is really simply because if you can keep inflation under control, the federal funds rate would start to lower and this will eventually stimulate the economy.
January 9, 2018
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