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Encyclopedia > Monetary policy of the USA

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How money is created

When money is deposited in a bank it can then be lent out to another person. If the initial deposit was $100 and the bank lends out $100 to another customer the money supply has increased by $100. However, because the depositer can ask for the money back, banks have to maintain minimum reserves to service customer needs. If the reserve requirement is 10% then in the earlier example the bank can only lend out $90 and thus the money supply increases only to $90. This relationship between increase in money supply and reserve requirement is expressed as:

 m = 1 / RR 

where

 m = money multiplier RR = reserve requirement 

Federal Reserve and money supply

The Federal Reserve has three main mechanisms for manipulating the money supply. It can sell treasury securities, which reduces the money supply (because it accepts money in return for a promise to pay in the future). It can also purchase treasury securities, which increases the money supply (because it pays out hard currency in exchange for accepting securities). Finally, the Federal Reserve can adjust the reserve requirement. The reserve requirement is directly related to the money multiplier as shown above.


Money supply, interest rates and the economy

When interest rates go down, money supply increases. Businesses and consumers have a lower cost of capital and can increase spending and capital improvement projects. This is encourages growth. Conversely, when interest rates go up, the money supply falls and reins in the economy. The Federal reserve increases interest rates to combat inflation.


Criticism of monetary policy

Some free market economists, especially those belonging to the Austrian School criticise the very idea of monetary policy, believing that it distorts investment. In the free market interest rates will be set by saver's time preference. If there is a high time preference this means that savers will have a strong preference for consuming goods now rather than saving for them. Thus interest rates will rise due to the low supply of savings. With low time preference interest rates will fall. The interest rates send signals to businessmen as to what is worth investing in, low interest rates will mean that more capital is invested. The Austrian School, also known as the Vienna School or the Psychological School, is a school of economic thought that advocates adherence to strict methodological individualism. ... Time preference is the economists assumption that a consumer will place a premium on enjoyment nearer in time over more remote enjoyment. ...


Monetary policy means that the interest rates no longer represent consumer time preferences and so investments are made by businessmen with the wrong signals. Lower than market interest rates will therefore mean a higher investment than the economy desires. This will mean that there will be capital goods that have been over invested, and will need to be liquidated. This liquidation is the cause of the depression that makes for the business cycle. // [edit] Introduction [edit] Definition If we were to take snapshots of an economy at different points in time, no two photos would look alike. ...


See also

Monetary policy is the process by which the government, central bank, or monetary authority manages the money supply to achieve specific goals—such as constraining inflation or deflation, maintaining an exchange rate, achieving full employment or economic growth. ... Money supply (monetary aggregates, money stock), a macroeconomic concept, is the quantity of money available within the economy to purchase goods, services, and securities. ...

External links

  • Savings rate viz Fed rate from 1954 Historical relationship between the savings rate and the Fed rate - since 1954

  Results from FactBites:
 
Inflation in Sweden, EU-15 and the USA | Financial Development | Economy | Facts and figures | ekonomifakta.se (313 words)
Inflation in Sweden, EU-15 and the USA
A very expansive economic policy financed by large budget deficits, generous wage increases, combined with repeated devaluations of the Krona, were the major causes of the substantial increase in inflation in Sweden.
The change in inflation policy and increasingly harder international price competition have also contributed to the historically low level of inflation in both Sweden and in other countries since the beginning of the 1990s.
  More results at FactBites »

 
 

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