Money and Monetary Policy

Money is the medium of exchange accepted by a society in payment for goods and services. The nation's money supply consists mainly of coins, bills, and checking and savings deposits.

The U.S. Federal Reserve Board is responsible for setting the nation's monetary policy - the regulation of the nation's supply of money and credit in order to keep the economy in balance. Through the nation's banking system, the Federal Reserve Board controls the availability of credit to consumers primarily in two ways - by determining the reserve ratio and by setting the discount rate.

The Reserve Ratio

Every lending institution, banks and savings and loan associations, must hold on to a certain amount of its deposits. This amount that cannot be lent out is called the reserve ratio. Most banks are members of the nation's Federal Reserve System (the Fed). By controlling the reserve ratio, the Fed determines the amount of money banks are able to lend. Suppose, for example, Janet wants to borrow ,000 to buy a new car, and Aaron wants to borrow ,000 to fix a leaky roof. They go to the same bank and apply for a loan. The bank uses money from depositors to lend to customers such as Janet and Aaron.

Suppose further, that the bank has ,000 in deposits and the Fed has established the reserve ratio at 10 percent. That means that the bank must keep

Money and Monetary Policy

Money is the medium of exchange accepted by a society in payment for goods and services. The nation's money supply consists mainly of coins, bills, and checking and savings deposits.

The U.S. Federal Reserve Board is responsible for setting the nation's monetary policy - the regulation of the nation's supply of money and credit in order to keep the economy in balance. Through the nation's banking system, the Federal Reserve Board controls the availability of credit to consumers primarily in two ways - by determining the reserve ratio and by setting the discount rate.

The Discount Rate

A second way in which the Fed influences the nation's economy is through athe discount rate. the discount rate is the rate of interest the Fed charges member banks to borrow money.

Banks make money by charging a higher interest rate on loans than they pay to those who deposit money into checking and savings accounts. Suppose, for example, that Jake deposits 0 in the bank at a 6 percent interest rate. If he leaves the funds on deposit for one year, he can collect 6 from the bank. This includes his 0 deposit, plus the in interest the bank owes him. During this time, however, the bank lends 0 to Samantha for a year. The bank charges her 15 percent interest. After one year, Samantha owes the bank 5. The bank then gives Jake his 6. The profit to the bank is . Obviously, the more money a bank has to lend, the more profit it can make.

To have more money to meet demand, banks often borrow from the Federal Reserve System. The bank then lends the money to its customers (borrowers) at a higher rate.

The Fed adjusts the discount rate to affect the supply of money. For example, if the discount rate is 5 percent, consumer banks might lend it out for 10 percent. If the discount rate were raised to 15 percent, consumer banks might charge 20 percent. Thus, you can see the impact a changing discount rate has on the availability of credit in the U.S. economy.