ECO 202 4-2 Monetary System Discussion Essay

ECO 202 4-2 Monetary System Discussion Essay

ECO 202 4-2 Monetary System Discussion Essay

How Changes to the Federal Funds Rate Affect the Unemployment Rate
The federal funds rate connotes the short-term interest rate charged between banks for loans (Mankiw, 2021). The federal funds rate is controlled by loan supply and demand in the market. This rate is influenced by the open market operations. The injection of reserves in the banking system reduces the essence of borrowing by the bank, which leads to the reduction of the federal funds rate (Mankiw, 2021). Usually, the components of financial systems are closely related and so, any changes in the federal funds rate automatically change other interest rates in a similar direction. The variation in the interest rates in any direction affects the supply of money. This rate increase discourages banks from borrowing money from other banks at elevated rates due to the higher costs of such borrowing. In turn, this reduces the money banks allocate for lending (Mankiw, 2021). The scarcity of money banks allocates for lending causes an increase in interest rates for traders and consumers borrowing from banks. This leads to a reduction in investment back to the market. The reduction in money to invest in the market causes a reduction in the need for labor (Mankiw, 2021). If this scenario continues, many people are driven out of employment in the market.

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How Changes to the Federal Funds Rate Affect the Inflation Rate
Inflation refers to the elevation in the entire price level in the economy (Mankiw, 2021). Federal funds rates are closely connected to interest rates. The increase and reduction in the interest rates manipulate the money supply and the monetary supply influences prices. The increase in the supply of money lowers the value of money and elevates the prices. The increase in prices increases inflation (Mankiw, 2021). On the other hand, a reduction in monetary supply elevates the monetary values and reduces the prices. The reduction in prices reduces inflation (Mankiw, 2021). When inflation is low, the interest rates are reduced by Federal Reserve to kindle the economy.

Mankiw, N. G. (2021). Principles of economics (9th ed.). Cengage Learning.


4-2 Discussion: Monetary System

The Federal Reserve controls the money supply through monetary policy actions.
In your initial post address the following:
• How do changes to the federal funds rate affect the unemployment rate? Explain by using information from the textbook.
• How do changes to the federal funds rate affect the inflation rate? Explain the relationship using information from the textbook.
This video will help to explain the Monetary Policy and the Fed- EconMovies #9: Despicable Me Monetary Policy and the Fed: EconMovies #9: Despicable Me.

Chapter 29-Conclusion
Some years ago, a book made the best-seller list with the title Secrets of the Temple: How the Federal Reserve Runs the Country. Though no doubt an exaggeration, this title highlighted the important role of the monetary system in our daily lives. Whenever we buy or sell anything, we are relying on the extraordinarily useful social convention called “money.” Now that we know what money is and what determines its supply, we can discuss how changes in the quantity of money affect the economy. We begin to address that topic in the next chapter.

Chapter in a Nutshell
• The term money refers to assets that people regularly use to buy goods and services.
• Money serves three functions. As a medium of exchange, it is the item used to make transactions. As a unit of account, it provides the way to record prices and other economic values. As a store of value, it offers a way to transfer purchasing power from the present to the future.
• Commodity money, such as gold, is money that has intrinsic value: It would be valued even if it were not used as money. Fiat money, such as paper dollars, is money without intrinsic value: It would be worthless if it were not used as money.
• In the U.S. economy, money takes the form of currency and various types of bank deposits, such as checking accounts.
• The Federal Reserve, the central bank of the United States, is responsible for regulating the U.S. monetary system. The Fed chair is appointed by the president and confirmed by the Senate every four years. The chair is the head of the Federal Open Market Committee, which meets about every six weeks to consider changes in monetary policy.
• Bank depositors provide resources to banks by depositing their funds into bank accounts. These deposits are part of a bank’s liabilities. Bank owners also provide resources (called bank capital) for the bank. Because of leverage (the use of borrowed funds for investment), a small change in the value of a bank’s assets can lead to a large change in the value of the bank’s capital. To protect depositors, bank regulators require banks to hold a certain minimum amount of capital.
• The Fed controls the money supply primarily through open-market operations: The purchase of government bonds increases the money supply, and the sale of government bonds decreases the money supply. The Fed also has other tools to control the money supply. It can expand the money supply by decreasing the discount rate, increasing its lending to banks, lowering reserve requirements, or decreasing the interest rate on reserves. It can contract the money supply by increasing the discount rate, decreasing its lending to banks, raising reserve requirements, or increasing the interest rate on reserves.
• When individuals deposit money in banks and banks loan out some of these deposits, the quantity of money in the economy increases. Because the banking system influences the money supply in this way, the Fed’s control of the money supply is imperfect.
• The Fed has in recent years set monetary policy by choosing a target for the federal funds rate, a short-term interest rate at which banks make loans to one another. As the Fed pursues its target, it adjusts the money supply.

Chapter 30-Conclusion
This chapter discussed the causes and costs of inflation. The primary cause of inflation is growth in the quantity of money. When the central bank creates money in large quantities, the value of money falls quickly. To maintain stable prices, the central bank must maintain strict control over the money supply.
The costs of inflation are more subtle. They include shoe leather costs, menu costs, increased variability of relative prices, unintended changes in tax liabilities, confusion and inconvenience, and arbitrary redistributions of wealth. Are these costs, in total, large or small? All economists agree that they become huge during hyperinflation. But during periods of moderate inflation—when prices rise by less than percent per year—the size of these costs is more open to debate.
This chapter presented many of the most important lessons about inflation, but the analysis is incomplete. When the central bank reduces the rate of money growth, prices rise less rapidly, as the quantity theory suggests. Yet as the economy makes the transition to the lower inflation rate, the change in monetary policy will likely disrupt production and employment. That is, even though monetary policy is neutral in the long run, it has profound effects on real variables in the short run. Later in this book we will examine the reasons for short-run monetary non-neutrality to enhance our understanding of the causes and effects of inflation.

Chapter in a Nutshell
• The overall level of prices in an economy adjusts to bring money supply and money demand into balance. When the central bank increases the supply of money, it causes the price level to rise. Persistent growth in the quantity of money supplied leads to continuing inflation.
• The principle of monetary neutrality asserts that changes in the quantity of money influence nominal variables but not real variables. Most economists believe that monetary neutrality approximately describes the behavior of the economy in the long run.
• A government can pay for some of its spending simply by printing money. When countries rely heavily on this “inflation tax,” the result is hyperinflation.
• One application of the principle of monetary neutrality is the Fisher effect. According to the Fisher effect, when the inflation rate rises, the nominal interest rate rises by the same amount so that the real interest rate remains the same.
• Many people think that inflation makes them poorer because it raises the cost of what they buy. This view is a fallacy, however, because inflation also raises nominal incomes.
• Economists have identified six costs of inflation: shoe leather costs associated with reduced money holdings, menu costs associated with more frequent adjustment of prices, increased variability of relative prices, unintended changes in tax liabilities due to no indexation of the tax code, confusion and inconvenience resulting from a changing unit of account, and arbitrary redistributions of wealth between debtors and creditors. Many of these costs are large during hyperinflation, but the size of these costs for moderate inflation is less clear.

Mankiw, N. G. (2021). Principles of economics (9th ed.). Cengage Learning.

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