The Discount Rate describes the interest rate at which the Federal Reserve lends to commercial banks. This rate differs from the Federal Funds Rate, which is the rate at which banks (and other private depository institutions) lend money to other banks (or other private depository institutions). A negative spread between the Discount Rate and the Federal Funds Rate, which occurs when the Discount Rate is lower than the Federal Funds Rate, signals an opportunity for banks and other institutions to borrow money at a lower than normal interest rate. This increased borrowing from the Federal Reserve introduces more money into the system; as McConnell & Brue describe it, “borrowing from the Federal Reserve Banks by commercial banks increases the reserves of the commercial banks and enhances their ability to extend credit” (2004).
Lowering the Discount Rate is a factor of Easy Money Policy (or Expansionary Monetary Policy). The purpose of this policy is to increase aggregate demand, output, and employment – all to combat economic recession and rising rates of unemployment. Raising the Discount Rate has the opposite effect and is a factor or Tight Money Policy (or Restrictive Monetary Policy), which is primarily used to reduce spending and control inflation. The Discount Rate has a direct influence in control of the money supply by making it easier or harder for commercial banks to increase their reserves and, in turn, the amount of credit available to extend to borrowers.
Required Reserve Ratio
The Required Reserve Ratio is the percentage of the deposits that banks must hold as reserves. In essence, the reserves are designed to satisfy withdrawal demands. A bank that lends out 100% of its funds has no ability to give deposits back to the consumer. If a bank maintains checkable deposits of $100,000, a current reserve of $20,000, and the required reserve ratio is 10%, then the amount required to be held as reserve is $10,000. This leaves the bank $10,000 in excess reserves that may be used for lending purposes. Manipulation of this ratio has a direct effect on a bank’s ability to lend. A rise in the required reserve ratio would translate to reduced excess funds in the reserve and, in turn, reduced availability of funds to lend. The opposite is true; a drop in the required reserve ratio would translate to increased excess funds and, therefore, greater available funds for lending. If the ratio were raised to 20% in the scenario above, the bank would be required to hold $20,000, matching what it currently holds in reserve. This bank no longer has excess funds and is unable to lend. If the ratio were lowered to 5% in the scenario above, the bank would be required to hold $5,000, increasing the reserve excess to $15,000 and increasing this bank’s ability to lend.
The influence of the Required Reserve Ratio is on the availability of money in the system. The effects of manipulation of this ratio are identical to the manipulation of the Discount Rate. A drop in the ratio immediately adds to the money supply and has the effects of increasing aggregate demand, output, and employment. A rise in the ratio immediately reduces the money supply in an effort to reduce spending and control inflation.
Open-market operations consist of the purchase or sale of T-bills, bonds, and other Federal instruments, and constitute “the [Federal Reserve’s] most important instrument in influencing the money supply” (McConnell & Brue, 2004). The Federal Reserve may increase the money supply by purchasing government bonds from commercial banks and securities from the public. Government bond purchase directly increases the reserves of a bank, allowing greater potential for lending which increases the money supply. Securities purchase indirectly increases the reserves of a bank: the Federal Reserve purchases securities from the public who then take the payment check and deposit the funds into a bank, thereby increasing that bank’s reserves. The opposite is also true: the Federal Reserve may reduce the money supply by selling bonds to banks and securities to the public. The enticement of purchase for banks and the public is the added interest that may be accumulated in holding these instruments.
In direct correlation to the Discount Rate and Required Reserve Ratio, the influence this tool has is on the availability of money in the system. The effects of the purchase and sale of these instruments are identical to the other two tools: either increasing aggregate demand, output, and employment, or decreasing spending and inflation.
Each tool of monetary policy – the Discount Rate, Required Reserve Ratio, and Open-Market Operations – influences macroeconomic factors. As described in the introduction, these factors consist of national output (GDP), inflation, and unemployment. The influence each tool has on these factors has already been discussed, but a more detailed analysis of the reasoning will be provided here.
The national output is measured through Real Gross Domestic Product, or Real GDP (GDP for short). Investopedia.com describes real GDP as an “inflation-adjusted measure that reflects the value of all goods and services produced in a given year, expressed in base-year prices” (2008). GDP is directly related to the money supply: an increase in money supply will serve to increase GDP; a decrease in money supply will serve to decrease GDP. The rationale in this is that higher levels of money spur investor and consumer demand. More money generally translates to greater purchasing power and so demand and output must rise to match.
The inflation rate is the “rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling”, according to Investopedia.com (2008). The inflation rate is directly related to the money supply: an increase in money supply will serve to increase the inflation rate; a decrease in money supply will serve to decrease the inflation rate. When the amount of money in the system increases and the nominal value remains the same, more money is available to purchase the same quantity of goods and services which, in turn, lowers the real value of money. This describes the reason an increase in money supply increases the inflation rate.
Moneychimp.com defines the unemployment rate as the “percentage of employable people actively seeking work, out of the total number of employable people” (2008). This rate is actually indirectly related to the money supply since it is directly related to the GDP. An increase in spending and investments spurs increased demand, as described earlier. As such, output may be raised to supply that demand through a larger workforce; hence, an increase in money supply will serve to increase GDP which will, in turn, reduce the unemployment rate.
The Best Monetary Policy
Unfortunately, there is no ‘best policy’ when it comes to maintaining continued economic growth, control on inflation, and low unemployment rates. Many outside forces contribute to these macroeconomic factors as may be witnessed in the Monetary Policy simulation found in the University of Phoenix rEsource. Each tool the Federal Reserve employs in efforts to achieve economic harmony have varied levels of effect and can be greatly influenced by outside forces, such as foreign production or prices. The best monetary policy that may be employed in such a situation is a dynamic policy, one capable of being changed the moment a new factor is introduced to the equation.
Inflation. (2008). Retrieved May 17, 2008, from Investopedia: http://www.investopedia.com/terms/i/inflation.asp
Macroeconomic Analysis. (2008). Retrieved May 17, 2008, from Investopedia: http://www.investopedia.com/articles/02/120402.asp
McConnell, C. R., & Brue, S. L. (2004). Economics: Principles, Problems, and Policies. The McGraw-Hill Companies.
Real Gross Domestic Product. (2008). Retrieved May 17, 2008, from Investopedia: http://www.investopedia.com/terms/r/realgdp.asp
Unemployment Rate. (2008). Retrieved May 17, 2008, from Moneychimp: http://www.moneychimp.com/glossary/unemployment_rate.htm