Economics: Principles, Problems, and Policies Chapter 15 Summary: Monetary Policy

As is true for fiscal policy, monetary policy is intended to achieve price stability, full employment within the full employment-unemployment rate definition, and economic growth. Monetary policy is largely decided by the Governors of the Board of the Federal Reserve Bank. The Federal Reserve Banks' most important assets are stock securities and loans to commercial banks. The Federal Reserve Banks' main liabilities are the reserves of member banks, Federal Treasury Deposits, and Federal Reserve Notes.

The three instruments of Federal Reserve monetary policy are (1) open-market operations, (2) the reserve ratio, and (3) the discount rate. Monetary policy implemented through these instruments operates in a complex cause-effect chain whereby (1) policy affects commercial bank reserves, (2) bank reserve changes affect changes to M money supply through changes in lending, (3) changes in money supply alter the interest rate, (4) changes in the interest rate affect business investment, (5) changes in business investment affect aggregate demand, and (6) changes in aggregate demand affect real GDP and price level. In addition, the Federal Reserve may directly state new target levels for the interest rate by stating the target level for the federal funds rate (overnight discount rate).

The advantages of Federal Reserve monetary policy are that the Fed can use monetary policy to stem rapid inflation and to steer the economy away from recession. Nearly all economists consider Fed monetary policy an important tool for economic stability. The limitations of Federal Reserve monetary policy are that global economy considerations make monetary policy more difficult to administer and the outcome much less certain. Another disadvantage is that the velocity of money (the rate at which a dollar changes hands for goods and services in a year) may partially alter the changes in money supply that are aimed at by monetary policy. Also, in a recession, firms may be reluctant to spend on capital goods, thus limiting the effectiveness of an expansionary monetary policy as implemented by the Fed.