The Effect Monetary Policy Has on Macroeconomics

The Effect Monetary Policy has on Macroeconomics.

Antonio C. Marks

University of Phoenix

MBA 501

Dr. Ronald E. Polk

April 4, 2007

The Effect Monetary Policy has on Macroeconomic Factors

Monetary policy includes the manipulation in the money supply by the Federal Reserve that will influence interest rates, which will cause a snowball effect in total overall spending. The change in interest rates, in many cases are a determining factor in the decision-making process to purchasing a house, a new car, borrow money for home improvements and many other decisions on purchases which will impact the total level of spending in the economy. The Federal Reserve has two main assets, securities and loans to commercial banks, thrifts-savings and loans, mutual savings and loans and credit unions. " Securities are government bonds that have been purchased by the Federal Reserve Banks. They consist largely of Treasury bills (short term securities), Treasury notes (mid-term securities), and Treasury bonds (long term securities) issued by the U.S. government to finance past budget deficits (Brue 2004)." "Although securities are an important source of interest income to the Federal Reserve Banks, they are mainly bought and sold to influence the size of commercial bank reserves and, therefore, the ability of those banks to create money by lending (Brue 2004)." By controlling the money supply and interest rates in the economy, macroeconomic factors are affected such as GDP, unemployment and interest rates.

How Banks Create Money

"When early traders began to use gold in making transactions, they soon realized that it was both unsafe and inconvenient to carry gold and to have it weighed and assayed (judged for purity) every time they negotiated a transaction. So by the sixteenth century they had begun to deposit their gold with goldsmiths, who would store it in vaults for a fee. On receiving a gold deposit, the goldsmith would issue a receipt to the depositor. Soon people were paying for goods with goldsmiths' receipts, which serviced as the first kind of paper money (Brue 2004)."

"At this point the goldsmiths-embryonic bankers- used a 100 percent reserve system; they backed their circulating paper money receipts fully with the gold that they held "in reserve" in their vaults. But because of the public's acceptance of the goldsmiths' receipts as paper money, the goldsmiths soon realized that owners rarely redeemed the gold that they held in storage. In fact, the goldsmiths observed that the amount of gold being deposited with them in any week or month was likely to exceed the amount that was being withdrawn (Brue 2004)."

Today, the U.S. Bureau of Engraving creates Federal Reserve Notes and The U.S. Mint creates coins. Checkable deposits make up over half the nation's MI money supply, and are created by loan officers who issue loans to consumers.

How Gross Domestic Product is affected

The economy's performance is measured by its yearly combined output of goods and

services, also called aggregate output. " Aggregate output is labeled gross domestic product (GDP); the total market value of all final goods and services produced in a given year. GDP includes all goods and services produced by either citizen-supplied or foreign-supplied resources employed within the country (Brue, 2006).

"The point of implementing policy through raising or lowering interest rates is to affect people's and firms' demand for goods and services (www.frbsf.org) ." "What are real interest rates and why do they matter? For the most part, the demand for goods and services is not related to the market interest rates quoted in the financial pages of newspapers, known as nominal rates. Instead, it is related to real interest rates--that is, nominal interest rates minus the expected rate of inflation. For example, a borrower is likely to feel a lot hap-pier about a car loan at 8% when the inflation rate is close to 10% (as it was in the late 1970s) than when the inflation rate is close to 2% (as it was in the late 1990s). In the first case, the real (or inflation-adjusted) value of the money that the borrower would pay back would actually be lower than the real value of the money when it was borrowed. Borrowers, of course, would love this situation, while lenders would be disinclined to make any loans (www.frbsf.org),"

Long-term interest rates reflect people's expectations on what the Fed will do in the future. If there is a concern that the rate of inflation has not stabilized, they will be

concerned that inflation will move up over time and during that period a risk premium will be added to long-term rates, which will make them higher. "Researchers have

pointed out that the Fed could inform markets about future values of the funds rate in a number of ways. For example, the Fed could follow a policy of moving gradually once it starts changing interest rates. Or, the Fed could issue statements about what kinds of developments the FOMC is likely to focus on in the foreseeable future; the Fed even could make more explicit statements about the future stance of policy (www.frbsf.org.)

The economy is affected by these policy-induced changes in real interest rates. Borrowers benefit from policy-induced changes that result in lower rates while lenders do not benefit as much by lending at these low rates. The Fed cannot set the real interest rate on loans because the Fed only operates in the market for bank reserves.

Lower rates also make certain investments like common stocks attractive, more so than bonds. This will typically cause common stocks to rise and those who invest in common stocks will benefit from a rise in value, which will make