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Financial Literacy | Monetary & Fiscal Policy (Part1 | Chapter5)

March 8, 2017

PART 1                    FINANCE, the BIG PICTURE





Policy makers always pursue positive Economic Growth, Lower Unemployment Rate, and Stable Consumer Prices.


In order to achieve these mandates, the government, mostly U.S. Treasury department and the president, employs various financial tools.


For example, if the economy is suffering from low growth, the government would reduce tax rates for both households and companies in order to encourage consumption and investments. Or, it can simply increase its spending to boost the economy.


These tools that the government employs are called Fiscal Policies. Fiscal policy is a direct means of intervention by the policy makers as they can specifically target certain part of the economy.


Another method to impact the real economy is adjusting the money supply.


For example, if the economy is overheating, the Fed would intervene by decreasing the money supply in the market and try to calm down the economy. What this means is that by making money scarce, it becomes more expensive to consume or invest, thus slowing down the economy.


Adjusting the money supply to impact the real economy is a tool commonly known as the monetary policy. Monetary policy is an indirect means of impacting the economy as policy makers cannot specifically pin out parts of the economy, but influence it as a whole. In the US, monetary policy is governed by the Federal Reserve System.


Federal Reserve System or the Fed is the central bank of United States. It controls and manages the money supply of the whole economy. And there are several ways for the central bank to control the money supply.


First of all, the Fed can use Open-Market Operations.


Via its trading desk at the Federal Reserve Bank of New York, the Fed can buy or sell various bonds. By buying bonds and paying to the sellers, Fed increases the money supply into the market, and vice versa.


The committee for Open-Market Operations is called the Federal Open Market Committee or FOMC. At the committee, they not only decide how much bonds they would buy or sell, but also sets the target Federal Funds Rate, which is the standard rate.


Another means of controlling the money supply by the Fed is by setting different levels of Reserve Requirements. All of the depository institutions are required to hold a certain portion of the deposits from the clients in the Fed system to ensure that banks are not short of cash when emergencies occur. And this portion of deposits that Banks have to keep in the Fed system is called the Reserve Requirements. As you can see, by increasing or decreasing the level of Reserve Requirements, the Fed can control the money supply by limiting the amount of money that depository institutions can lend out to the economy.


Lastly, there is Discount Rate. The Fed operates discount window for financial institutions to borrow money from the Fed. By adjusting this discount rate, the Fed can adjust money supply to financial institutions.

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