Monetary policy effect on Macroeconomics

Monetary policy is the method by which the government, central bank, or monetary authority controls the supply of money, or trading foreign exchange markets. This policy is usually called either an expansionary policy, or a contractionary policy. An expansionary policy multiplies the total supply of money in the economy, and a contractionary policy diminishes the total supply. Expansionary policy is used to tackle unemployment in an economic decline by lowering interest rates, while contractionary policy has the goal of elevating interest rates to fight inflation. Monetary policy reposes on the relationship between the rates of interest in an economy and the total dispense of money.

Monetary policy uses a diversity of tools to dominate exchange rates with other currencies and unemployment. This is done in order to influence outcomes like economic growth and inflation. A policy is called contractionary if it diminishes the size of the money supply or increases the interest rate. An expansionary policy raises the size of the money supply, or lowers the interest rate. Monetary policies are accommodative if the interest rate is intended to stimulate economic growth, neutral if it is intended to neither encourage growth nor fight inflation, or tight if its aim is to reduce inflation.

There are several monetary policy tools available to achieve these results. The Fed has three of these tools. Open market operations, reserve requirements and discount window lending. Open market operations are the most important tool of monetary policy used by the Fed. These operations involve the Fed buying and selling prior issued U.S. government securities. Reserve requirements are the percentages of precise kinds of deposits that banks must keep in their vaults or deposit at a Federal Reserve Bank. Banks and other institutions keep a certain amount of funds in reserve to meet unforeseen outflows. Banks keep these reserves as cash in their vaults or as deposits with the Fed, which they are required to do. The Fed has the authority to set reserve requirements on checking accounts and certain types of savings accounts.

Discount rate is the interest rate that the Fed charges banks for short-term loans. Banks can borrow reserves directly from the Federal Reserve and the discount rate is the rate that financially solvent banks must pay for this credit. Changes in the discount rate typically occur together with changes in the federal funds rate.

Monetary Policy and its effect on Gross Domestic Product

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Monetary Policy and its effect on Gross Domestic Product

Gross Domestic Product (GDP) is the total market value of all final goods and services produced in a given year (McConnell 2004). This is one way of measuring the size of the economy. It is usually compared to the previous quarter or year. Economic growth is calculated as a percentage rate of growth per quarter (3-month period) or per year (McConnell & Brue, 2008). Goals of Federal Reserve policy are to maximize employment and keep inflation on a descending track until price stability is accomplished. Economic growth promotes employment, which in turn helps the economy. An economy that is experiencing economic growth is better able to meet people's wants and resolve socioeconomic problems. Rising real wages and income provide richer opportunities to individuals and families—a vacation trip, a personal computer, a higher education—without sacrificing other opportunities and pleasures (McConnell & Brue, 2008).

Fundamentally, the Federal Reserve controls only one thing; the volume of bank reserves held by U.S. banks. To control bank reserves, the Federal Reserve buys or sells Treasury bills in the open market, either taking reserves away from banks or giving banks reserves. On that, there is basically no choice. Measuring GDP is complicated but the calculation can be done in one of two ways: either by adding up what everyone earned in one year (income approach), or by adding what everyone spent (expenditure method). Both measures should arrive at approximately the same total. A significant change in GDP, up or down, usually has a significant effect on the stock market. It's not hard to understand why: a bad economy usually means lower profits for companies, which in turn means a decrease in stock prices. Growth lessens the burden of scarcity (McConnell & Brue, 2008).

Monetary Policy effect on Unemployment

When the economy is healthy, you will generally see low unemployment and wage increase as businesses demand labor to meet the economy. Monetary policy has two basic goals: to promote "maximum" output and employment and to promote "stable" prices (Money 2008). Since the Fed cannot control inflation or affect output and employment directly it makes and impression indirectly, through raising or lowering short-term interest rates. Although the U.S. economy has experienced remarkable economic growth over time, high unemployment or inflation has sometimes been a problem (McConnell & Brue, 2004).

In order to measure unemployment, one must first identify who is qualified and accessible to work. There are three kinds of unemployment: Frictional unemployment, structural unemployment, and cyclical unemployment. Some workers are "between jobs." Some of them will be moving voluntarily from one job to another. Others will have been fired and will be seeking reemployment. Still others will have been laid off temporarily because of seasonal demand. In addition to those between jobs, many young workers will be searching for their first jobs (McConnell & Brue, 2008). Frictional unemployment blurs into a category called structural unemployment. Here, economists use "structural" in the sense of "compositional." Changes over time in consumer demand and in technology alter the "structure" of the total demand for labor, both occupationally and geographically (McConnell & Brue, 2008). Cyclical unemployment is caused by a decline in total spending and is likely to occur in the recession phase of the business cycle. As the demand for goods and services decreases, employment falls and unemployment rises (McConnell & Brue, 2008).

Unemployment brings a great cost to the economy. When the economy fails to create enough jobs for all who are able and willing to work, potential production of goods and services is irretrievably lost (McConnell & Brue, 2008).

Inflation

Inflation is a rise in the general level of prices. When inflation occurs, each dollar of income will buy fewer goods and services than before. Inflation reduces the "purchasing power" of money (McConnell & Brue, 2008). Inflation tends to rise or fall depending on the unemployment rate. If the unemployment rate is very high or low relative to historical experience, the implications for future inflation are fairly obvious. However, unemployment rates in the intermediate range are usually difficult to interpret (Money 2008). There are two types of inflation: Demand-pull Inflation and Cost- push Inflation.

Interest rates

Monetary policy causes an increase in bond prices and a decrease in interest rates. A free market rate of interest is a composite of three factors: the originally rate of interest, the risk premium, and the price inflation or deflation (rare since 1933) premium (North 2006).

Conclusion

It is amazing at how little we know about where our money goes or comes from. Many people are content with the simple knowledge that our money goes in our banks of choice. However, things are not as simple as they seem. Our money goes somewhere and it affects us all where it ends up. It is obvious that everything is interrelated. Every decision made has an impact on the bigger picture. Monetary policy can have a positive as well as a negative effect on everyday people. This can be manifested primarily through a shift in employment status. The government, however, has many tools in order to help the situation. These tools at time can improve or even deteriorate the dilemma. They are made to bring the economy out of crisis. But there is no doubt that monetary policy has a tremendous effect on macroeconomic factors as GDF, unemployment, inflation, and interest rates.

References

Anonymous (2007). Money what it is how it works. Retrieved February 18, 2008, from

http://wfhummel.cnchost.com/monetarypolicy.html

McConnell, C.R. & Bruce, S.L. (2004). Economics: Principles, problems and policies. (16th ed.).

New York: McGraw-Hill.

North, Gary (2006). Interest Rates and Monetary Policy. Retrieved February 18, 2008, from

http://www.lewrockwell.com/north/north492.html