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U.S. Federal Reserve Monetary Policy Essay

McConnell and Brue, in their distinguished book, Economics: Principles, Problems, and Policies explain clearly the functions of money in any economy. It serves as a means to facilitate easy transactions. (McConnell and Brue, 2004, 200).  Without money, all transactions would have to be carried out through barter trade which involves direct exchange of goods for goods or a service for another. One of the difficulties with a barter system is that, in order to obtain a particular good or service from a supplier, one has to possess a good or service of equal value as which the supplier also desires.

However, the likelihood of a double coincidence of wants is small and makes the exchange of goods and services rather difficult. Money effectively eliminates the double coincidence of wants problem by serving as a medium of exchange that is accepted in all transactions, by all parties, regardless of whether they desire each others’ goods and services. (McEachern W, 2005, 598). Money is also used as a store of value where it must hold its value over time.

If money could not be stored for some period of time and still remain valuable in exchange, it would not solve the double coincidence of wants problem and therefore would not be adopted as a medium of exchange. As a store of value, money is not unique; many other stores of value exist, such as land, works of art, and even baseball cards and stamps. Money may not even be the best store of value because it depreciates with inflation.

However, money is more liquid than most other stores of value because as a medium of exchange, it is readily accepted everywhere. It is also an easily portable store of value that is available in a number of convenient denominations.  Money also functions as a unit of account, providing a common measure of the value of goods and services being exchanged. (McConnell and Brue, 2004, 200).   Knowing the value or price of a good, in terms of money, enables both the supplier and the purchaser of the good to make decisions about how much of the good to supply and how much of the good to be purchased. (Lustig N 1998). This paper focuses on the effect of Federal Reserve monetary policy on the U.S. economy and money functions.

The Federal Reserve System commonly known as FED is the US central Bank which has the power to execute monetary policies that influence the supply as well as the demand for money in US. The monetary policies at its disposal include the changing or influencing of the reserve requirement, the discount rates as well as through the open market operations. Open market operations refer to the purchasing or buying of the US treasury as well as the federal agency security to influence the demand and supply of money to the desired levels. (www.federalreserve.gov). The open market operation where government bonds are sold or bought is the most important monetary tool of Fed.

The Reserve requirement refers to the money or funds that commercial banks as well as other depository institutions must deposit with Fed in terms of reserves against the set deposit liabilities. The board of governors of Fed stipulates within the law the reserve requirements and makes relevant changes. The reserve requirement is held in form of vault cash. Depository institutions include commercial banks, savings banks, saving and loan associations, credit unions, branches and agencies of foreign banks in US, edge corporations as well as agreement corporations. (www.federalreserve.gov).

The required reserve ratio is the ratio of reserves to deposits that are obligated by regulation to hold. If there is high money supply in the economy the federal banks raises the reserve requirement ratio so that banks have less liquid assets at their disposal and hence little to lend to people. (McEachern W, 2004, 642).

The major objective of the monetary policies set or rather adopted by Fed is to maximize or rather raise the employment levels, ensure moderate long term interest rates as well as stable prices by checking on inflation. (www.federalreserve.gov). All this is done to ensure that investment is encouraged and consequently economic growth is promoted. Low market interest rates other factors held constant lowers the cost of holding money and people hold their money in liquid form.

High interest rates increase the cost of holding money and more money is held in form of assets rather than in liquid. The money multiplier magnifies a change in initial spending into the GDP. It magnifies the excess reserves into a large creation of checkable deposit money. (McEachern W, 2004, 263). Price stability is important in as far as economic growth is concerned. It is an incentive to investment and it also positively influences the consumer confidence levels. The overall effect of this is that there is economic growth and people’s standards of living are boosted. When prices are unstable or fluctuating there is a higher risk involved as people may incur losses when their assets lose value due to inflation.

Currently the US economy continues to register a downward trend that is characterized by increased unemployment rates, reduced consumer confidence levels and strict credit condition. Fed has used its monetary policies to promote economic growth while ensuring price stability. It has increased the federal funds rate. It has continued to purchase the mortgage backed securities in an effort to increase people’s purchasing power as well as the consumer confidence levels and this will see the economy register a positive growth.


Board of Governors of the Federal Reserve System. Federal Open Market Committee

FOMC. Monetary Policy. Retrieved on 4th April 2009 from http://www.federalreserve.gov/monetarypolicy/fomc.htm

Board of Governors of the Federal Reserve System. Federal Open Market Committee

FOMC. Monetary Policy. Retrieved on 4th April 2009 from


Lustig, N. 1998. The Remarking of an Economy. Mexico: Brookings Institution Press,

McConnell, C and Brue S. 2004. Economics: Principles, Problems, and Policies.

            McGraw-Hill Professional Publishers. p 200-345.

McEachern W. 2005. Economics: A Contemporary Introduction. Thomson South-

            Western Publishers, p 600-648

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