This paper is a discussion of how a monetary policy effects specific macroeconomic factors as GDP, unemployment, interest rates and inflation. Included in the discussion is how different combinations of monetary policy tools are utilized to manage an economy. Monetary Policy and Its Effect on Macroeconomic Factors
Monetary policy consists of deliberate changes in the money supply to influence interest rates and thus the level of spending in the economy. The goal of a monetary policy is to achieve and maintain price level stability, full employment and economic growth. (McConnell & Brue, 2004, p. 268, ¶ 1)
A basic discussion on how commercial banks and the banking system create money is needed to understand how the Fed utilizes tools at its disposal to implement a monetary policy.
The United States has a fractional reserve banking system in which only a fraction of the money supply is held in reserve as currency. (McConnell & Brue, 2004, p252, ¶ 5) Since the U.S. utilizes this type of system the Fed has placed restrictions on commercial banks to ensure that proper banking practices are followed, among the restrictions is a reserve ratio requirement. A Reserve is a requirement that all commercial banks must maintain cash on hand to equal a predetermined percent of the checkable deposits liabilities that a bank currently holds or a reserve ratio. Therefore a bank can lend only an amount equal to its excess reserves. For example, if a bank has $100 in checkable deposits and the reserve ratio is 10% then the bank must hold back $10 as a reserve, that is the bank can only loan out $90 not the full $100. The primary purpose of the reserve ratio is to control a banks ability to lend and prevent the bank from overextending credit or under extending credit. (McConnell & Brue, 2004, p.256, ¶ 3)
A bank creates money through the creation of loans. That is a bank takes a promissory note, an IOU, in exchange for an interest earning line of credit...