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Likewise this cycle of purchases can be broken with a tightening of the money supply, having a negative impact on the GDP.
Unemployment is affected as well. As money supply is loosened, businesses are encouraged to expand. Capital is more readily available to finance expansion, and a growing GDP further encourages this expansion by providing more money in the market to purchase the new goods or services that the expansion creates. Some of this investment will generate new jobs, lowering unemployment. Conversely, a tightening of the money supply will discourage the creation of new jobs.
2a) Money is created in three ways. First, open-market operations create money. When the Fed buys securities from the banks, it does not pay for them. Instead, it creates a credit on the balance sheet. This credit then enters the economy when the bank subsequently lends it. Open market operations are conducted with the objective of influencing the federal funds rate.
Essentially, the Federal Reserve either purchases or sells U.S. government securities. These transactions are conducted on the open market in a competitive environment, hence the term "open-market operations."
These securities can be issued by the U.S. Treasury, Federal agencies and government-sponsored enterprises.
A second way the Fed can create money is simply by printing more. This tool is not commonly used to influence monetary policy, as the amount of physical money is only a small proportion of total money supply. Printed money supply is generally based more on the demand for the physical version of money than the need to create more money in the economy. Based on this demand, the Fed either issues currency to the banks or takes in currency from the banks.
2b) One of the Fed's main roles is to achieve price stability. This is because inflation reduces the value of money, which in turn has a negative impact on the economy. The need to keep inflation in check must be balanced against the need to encourage economic growth, which in turn provides a reasonable level of unemployment. The goal of the Fed is to strike a balance between these factors. If the money supply is loosened too much, inflation will rise and the value of money will decrease. If the money supply is too tight, inflation will not be an issue but the economy will falter due to lack of investment, and this will result in an increase in unemployment.
In terms of preferred monetary policy, the Fed is partial to open-market operations. Over time they have used various means as their primary tool for managing money supply, but open-market operations have the advantage of dealing in a competitive market with a variety of private dealers, which makes this option is the most flexible.
The Fed has what is known as the Open Market Committee (FOMC), and they meet every six weeks to determine the overnight rate. This method is closely related to the open-market operations, which are conducted with an eye to influencing the overnight rate. The announcement of the overnight rate, however, has the benefit of being visible to the public at large. The treasury activity that seeks to guide the overnight rate is not so easily interpretable as the announcement of the overnight rate. The rate announcement sends a loud and public signal of Federal Reserve policy to the nation and the world. This makes it a highly effective communication tool in that it reaches a far wider audience of business leaders and investors than do the open-market operations.
This combination of monetary policies allows the Fed to frequently and regularly not only make shifts in money supply but to communicate those shifts to the nation. This allows for a more rapid market reaction to the shifts, which in turn allows for the desired affects of the policy to spread more quickly. This allows the Fed to keep up with changes in the economy, inflation and the unemployment rate.
Schwartz, Anna J. Money Supply. The Concise Encyclopedia of Economics. Online at http://www.econlib.org/library/Enc/MoneySupply.html. Accessed April 3, 2008.
Johnson, Manuel. The Federal Reserve System. The Concise Encyclopedia of Economic. Online at http://www.econlib.org/LIBRARY/Enc/FederalReserveSystem.html. Accessed April 3, 2008.
Coghill, Carrie. November 2005. Impact of the Federal Reserve System. Physician's News Digest. Online at http://www.physiciansnews.com/finance/1105.html. Accessed April 3, 2008[continue]
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