Monetary Policy
Monetary policy is used by the government to control and influence the supply of money in the economy. Understanding this policy, and its influences, affects the way many people make financial decisions in our country today. Monetary policy is used to adjust macroeconomic factors like inflation, unemployment, interest rates, and gross domestic output (GDP). These factors will influence people's decisions to spend on goods and services. To control these factors, the government uses tools such as the spread between the discount rate (DR) and the federal funds rate (FFR), the required reserve ratio, and the open market operations.
Understanding how money is created and destroyed will help understand the factors of monetary policy. Money is created and destroyed by loaning practices of a bank. A bank is only required to keep a portion if the money deposited in it called reserves. It can then loan out the money deposited into it. When a loan in created, a person goes into a bank with nothing but an IOU and walks out with money. Banks can create money through checkable deposits when they loan money. So in turn, money is destroyed when the loans are repaid. When the loan is repaid, the money borrowed is returned to the bank and the IOU is given back to the borrower. This reduces the money supply by the amount borrowed since the amount of checkable deposit has been eliminated and the money is not accompanied by an increase anywhere else in the economy (McConnell and Brue, 14, p. 259). So what determines how much money a bank can loan? This is where its reserves come into play.
The required reserve ratio is the percentage of deposits that a bank is required to hold as reserves. This percentage is regulated by the Federal Reserve System (FED) and is one of the tools it uses to control the money supply. If the FED raises the reserve ratio, this means banks are required to keep more money in reserves and are then able to lend out less money to...
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