Monetary
Policy
Monetary
policy concerns the amount of dollars available in the economy for purchases,
investments, and loans. While matters of
the federal budget do affect the money supply, the number of dollars available
in the economy is powerfully influenced by the Federal Reserve System, frequently termed simply, the Federal Reserve, or by the even
shorter appellation, “The Fed.”
The Federal
Reserve System
The Federal
Reserve is comprised of twelve (12) districts in major urban centers across the
United States, each functioning as a kind of supra-bank for the member banks in
its district. Banks that are federally
insured by the FDIC (Federal Deposit
Insturance Corporation) and thus part of each district’s network of banks,
are required by law to maintain a certain percentage of the money deposits in
reserve, either at its own bank or at the district federal reserve bank. The amount required for each bank varies
according to the size and value of the holdings of the bank, but in recent
years the ratio to total deposits in the bank has fallen between 8% and 18%.
The Fed
monitors the health of the economy as measured in job growth, percentage of the
work force employed; expansion of
activity by small businesses, medium-sized firms, and corporations; and the relationship of wages to prices.
When prices rise
significantly faster than wages, this condition is one indicator that inflation
has become a problem. Generally a 2%
annual rate of inflation is acceptable as long as unemployment is not much
higher than about 5%. If unemployment
rises above 5%, wage growth also tends to lag, and prices rising faster than
the 2% level would become a problem.
Sustained
stagnation in wage growth, business inventories, housing construction, and
automobile production serves as an indicator that the economy needs stimulation. While free market purists dislike heavy
government spending, in recent times (including, notably, the period during 2009
when recession [two
successive quarters of no economic growth or negative economic growth] hit the
economy) the federal government has in fact acted to inject money into the
economy. At the level of fiscal policy,
government spending stimulates the
economy with investments in infrastructure and social programs in ways that
create jobs and motivate entrepreneurs to expand businesses. At the level of monetary policy, the Fed acts
to inject additional dollars into the economy in three main ways:
First, the
Fed can reduce reserve ratios of its member banks so as to increase the amount
of money available to those banks to lend to individuals and businesses.
Second, the
Fed can set interests rates low, so that its member banks may borrow at lower
cost from the federal district bank (one of the twelve--- the one located in a bank’s district.)
Third, the
Fed (as an institution operating at the national level) is authorized to buy--- paying generously in making the
purchases--- U. S. Treasury bonds from
current holders, who deposit the
money in
their own banks, which then have more available to lend to individual customers
who want to buy cars, houses, and other major items; and to businesses that seek to hire more
workers, purchase equipment, build new facilities.
Conversely,
if the economy shows signs of overheating---
with inflation high and businesses seeming to expand recklessly--- the Fed may act along the same lines as given
above--- but in the opposite
direction--- 1) raising the reserve
ratios; 2) increasing interest rates; and 3) selling bonds at favorable rates, so
as to bring dollars off the private market and into the Fed’s own vaults.
The
Nobel-prizewinning economist Milton Friedman was a monetarist who thought that the Fed would do better to
expand the money supply at a slow, steady rate--- theoretically decreasing uncertainty--- rather than alternately to increase or
decrease the money supply. But ever
since the Great Depression, most economists have agreed that some flexibility
in decreasing or increasing the money supply is necessary.
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