Monetary Policy Macroeconomics Term Paper

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Monetary Policy

In the United States, the Federal Reserve system is charged with implementing monetary policy (Investopedia, 2013). Monetary policy is essentially any the output of any central bank that seeks to manage an economy by means of manipulating the supply of money in the economy (Investopedia, 2013). The Federal Reserve (2013) defines monetary policy as what it does to "influence the amount of money and credit in the U.S. economy." Thus, monetary policy affects not only the quantity of money but the cost of money and these factors directly affect the broader market with respect to investment, manufacturing output and overall economic activity.

The Federal Reserve uses monetary policy for three main purposes. The first is to management the GDP, the second is to manage inflation and the third is to manage unemployment. The Fed seeks to strike a balance between these three objectives with its policy, and the result of this approach is that it will use the different monetary policy levers to stimulate growth, or in other cases to slow growth if the inflation rate is getting too high. The two approaches are known as expansionary and contractionary, for their effects. The current monetary policy is expansionary in nature. This is because GDP growth is slower than where it should -- there is a gap between the actual GDP level and the potential GDP level (Gavin, 2012). In addition, the unemployment rate is higher than it should be, and inflation rates are still low. Thus, expansionary monetary policy is necessary to stimulate economic growth, by adding more money into the banking system.

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The following chart illustrates the GDP gap and why the current monetary policy strategy is expansionary:

There are three main tools of monetary policy. These are the discount rate, the reserve requirements and open market operations. These things affect the supply and cost of money in order to have an impact on the supply of money in the economy. This paper will discuss these different factors in turn, explaining their relevance to monetary policy.

The discount rate is the rate at which the central bank lends to different financial institutions. This rate is critical because it sets the baseline for the rate at which the banks will lend out to their customers. What the discount rate does is that it sets the cost of money in the economy. Most monetary policy affects the supply or demand for money, while this method affects the price money directly. This of course does have an effect on the supply of money but ultimately it is important to understand the supply of money in the economy is affected by the price.

What happens is that when the central bank raises the interest rates, the result is as follows. The cost of borrowing increases for banks. This does not necessary affect the amount that the banks will borrow, but it could. It does, however affect the rates at which those banks will lend out. What typically happens is that the banks will take money in, and then the lend out at a higher rate. The spread between the rate at which the banks borrow and which the banks.....

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