The Economy and Economic Policy
A country’s economy reflects the supply and demand of goods and services produced within it. A country’s Gross National Product (GNP) is the total value of all the final goods and services produced in a year by the factors of production owned by its residents. GNP is a measure of the state of the economy. It is used to facilitate economic policy making.
The economy’s status and prospects are affected by business cycles, fluctuations of the money supply, and economic policy. Economic policy has two components: monetary policy and fiscal policy.
Monetary policy is implemented through control of the money supply. In the United States, monetary policy is determined by the Federal Reserve Board. Fiscal policy is implemented through government spending, taxation, and borrowing. In the United States, the Congress and the President determine fiscal policy.
The Federal Reserve Board affects the money supply through its policy tools: changes in reserve requirements, changes in the discount rate, and open market operations.
Reserve requirements are deposits that commercial banks must place with the Federal Reserve. Commercial banks are required to deposit a specified minimum percentage of their depositor’s money at Federal Reserve Banks. The money commercial banks deposit with the Federal Reserve is not available for the banks to loan. Thus, by changing the reserve requirements the Federal Reserve affects the amount of money available for lending.
Federal Funds Rate
The total amount of money deposited by commercial banks at the Federal Reserve is called federal funds. If a bank finds that it cannot meet the reserve requirement, for example because the Federal Reserve has raised the required percentage, it may borrow federal funds from another member bank that has deposits exceeding the minimum requirement. The bank lending the federal funds will charge interest on the loan. The interest that commercial banks charge other banks for federal funds loans is called the federal funds rate.
The federal funds rate varies daily. A rising rate indicates a reluctance of the banks to lend money. A decreasing rate suggests that banks have excess deposits and are seeking to loan more money. Commercial banks, federal agencies, thrift institutions, branches and agencies of foreign banks in the United States, and government securities dealers take part in the federal funds marketplace.
Federal funds transactions may be initiated by a funds borrower or a funds lender. Typically, an institution seeking to lend federal funds identifies a borrower directly, through an existing banking relationship, or indirectly, through a federal funds broker. Lending depository institutions usually transfer funds by authorizing their district Federal Reserve Bank to debit their reserve account and credit the reserve account of the borrowing institution.
Instead of borrowing federal funds from another bank, a bank may borrow funds directly from the Federal Reserve at the discount rate. The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility, the discount window.
The Federal Reserve Banks offer three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit. Each program has its own interest rate. All Federal Reserve discount window loans are fully secured.
The Federal Reserve may affect the money supply by changing the discount rate. If the discount rate is lowered, the cost of money to banks is less, and this increases the availability of money for bank loans. If the discount rate increases, the cost of money to banks is greater, and demand for loans is reduced.
Open Market Operations
The Federal Reserve, acting through the Federal Open Market Committee, affects the money supply by buying and selling United States Treasury and federal agency securities. When the Federal Open Market Committee sells securities, it decreases the amount of money in the banking system. When it buys securities, it increases the supply of money in the banking system.
Fiscal policy is implemented by the Congress and the President. Federal spending, federal individual and business taxes, and federal budget deficits and surpluses, affect economic activity and the demand for goods and services. Lowering tax rates tends to increase the amount of money available to obtain goods and services. Increasing taxes tends to reduce the amount of money available for investing and for purchasing goods and services.
If the money supply remains constant, changes in demand for goods and services tend to affect the rate of inflation. Increasing the demand for goods and services tends to increase inflation. Reducing the demand for goods and services tends to reduce the rate of inflation.