Monetary Policy and the Federal Reserve
Money doesn't grow on trees. How often has one heard that cliche? But if horticulture cannot produce dollars and cents, then how is money created? One rather flip answer might be that money's value is created because the government 'says so.' Despite the sarcasm inherent in this comment, there is a trace of accuracy to the statement. Money is essentially an empty 'thing,' a placeholder rather than a substance of actual value. Once upon a time, the gold standard held sway, meaning that all U.S. funds were backed by gold held in the vaults of Fort Knox. However, this is no longer the case. "The abandonment of convertibility of money into a commodity since August 15, 1971, when President Nixon discontinued converting U.S. dollars into gold at $35 per ounce," causing most other nations to follow suit, "has made the U.S. and other countries' monies into fiat money-money that national monetary authorities have the power to issue without legal constraints." (Schwartz, 2002) To prevent the willy-nilly printing of money and inflationary growth, the Federal Reserve enforces certain constraints upon the circulation of money. For example, "the Federal Reserve requires commercial banks and other financial institutions to hold as reserve
On a macroeconomic level, this means that businesses produce less goods in the wake of decreased demand, and unemployment is likely to rise. To fuel economic expansion, the Federal Reserve can lower the reserve requirement, giving banks more available currency to lend, allowing consumers to buy more goods, and thus encouraging the economy to produce more goods and offer more services. Banks hold these reserves either as cash in their vaults or as deposits at Federal Reserve banks. Treasury securities by writing a check drawn on itself. The opposite sequence occurs when the Federal Reserve sells Treasury securities: the purchaser's deposits fall and, in turn, the bank's reserves fall. Conversely, a lower discount rate means banks have more money to borrow, and more available currency to lend, a policy designed to fuel economy growth. This affects how much money they must pay for car loans, on student loans, and other common forms of money lent at interest. The bank, in turn, deposits the Federal Reserve check at its district Federal Reserve Bank, thus increasing its reserves. Unfortunately, even the most seasoned economists find it difficult to strike a balance between these different factors, to generate just the right amount of economic growth so that inflation is kept in check yet unemployment does not grow too high. For the consumer able to save money, their money can 'make money for them' if the interest rate is high. Conversely, to fuel the economy, the Federal Reserve will lower the interest rate, making it less attractive to save money, and more attractive to spend money. If banks must hold a higher level of funds in reserve, the banks will have less money to lend, thus the money supply circulating within the national economy contracts. This would be an anti-recessionary policy, as opposed to an anti-inflationary policy. When the Fed wishes to curtail inflation and an economy spiraling out of control, it will raise the interest rate, discouraging consumer borrowing and spending and making it more attractive to save money.
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