Monetary policy of the USA

The purpose of this article is to explain the current implementation of monetary policy in the United States, as well as some of the financial details behind the current methods.

How money is created - Simplified
When money is deposited in a bank, it can then be lent out to another person. If the initial deposit was $100 and the bank lends out $100 to another customer the money supply has increased by $100. However, because the depositor can ask for the money back, banks have to maintain minimum reserves to service customer needs. If the reserve requirement is 10% then, in the earlier example, the bank can lend $90 and thus the money supply increases by only $90. The reserve requirement therefore acts as a limit on this multiplier effect.

Federal Reserve and Money Supply
The Federal Reserve has three main mechanisms for manipulating the money supply. It can buy or sell treasury securities. Selling securities would have the effect of reducing the money supply (because it accepts money in return for purchase of securities). Purchasing treasury securities would increase the money supply (because it pays out hard currency in exchange for accepting securities). Secondly, the discount rate can be changed. And finally, the Federal Reserve can adjust the reserve requirement

How Money is Placed into Circulation
Currently, the US government maintains over 800 billion US dollars in circulation throughout the world. Below is an outline of the process which is currently used to increase the amount of money in the economy, basically a summary of one of the most important functions of the Federal Reserve. The amount of money in circulation is generally increased to accommodate the growth of the country's production. This monetary policy is implemented by the Federal Reserve System - the quasi-public central bank of the United States.
# This first step is required for processes which occur later. Prior to expansion of the amount of money in the US Economy, we'll assume that Congress has - at some point - needed more money than it had taken in through taxes. In order to raise money, it increases the amount of the National Debt by ordering the creation of what laymen could refer to as an I.O.U. - typically, this will be a Treasury Bond (see Treasury security). It offers the "IOU" for sale, and someone pays cash to the government for that Treasury security. The Treasury securities generally do pay about 5% interest to the owner. It is these IOUs that will play a role later in the process. Note that sometimes your local bank is the one to buy the Treasury securities.
# The 12-person Federal Open Market Committee, consisting of the heads of the Federal Reserve System, meets eight times a year to determine how they would like to influence the economy. They create a plan called the country's "monetary policy" which sets targets for things such as interest rates.
# Your local bank goes through it's daily transactions. Of the total money deposited at banks, only a small bit of it ever is removed. So, banks decide to make use of this bulk of "non-moving" money by loaning it out. Banks do have a legal requirement to keep a certain percentage of money on-hand at all times.
# According to the estimates in its plan for the US Economy, the Federal Reserve places an order for money with the US Treasury Department. The Treasury Department sends these requests to its operations called the Bureau of Engraving and Printing (to make the paper dollar bills) and the Bureau of the Mint (to stamp the coins).
# The US Treasury sells this newly printed money to the Federal Reserve for the cost of printing. This is about 6 cents per bill (even the 100 dollar bills). Aside from the minimal costs, the only other obligation made is that the Federal Reserve has to simply pledge collateral for the money received.
# Every business day, the Federal Reserve System engages in what is called "Open market operations." If the monetary policy has planned to increase the amount of US dollars floating around, then they will hold small bidding contests to buy US Treasury Bonds from banks. So, the banks will send those government IOUs to the Federal Reserve and the Federal Reserve will send that newly printed money to the local bank. The reverse is often done as well, but generally, at the end of the year, there will be more money sent out to local banks, than money taken in from them.
# In trading, the Fed will have affected the available or "free reserves" of commercial banks in the country.
# Now that the local bank has more free reserves it loans out the money, because holding the money would amount to accepting the cost of foregone interest and commercial banks generally act to avoid such costs. This is how additional money is placed into the hands of the American public --- through bank loans.

In, summary, almost every US Dollar↑↑ anywhere in the world represents a current outstanding loan of some US citizen somewhere.

↑ Though the Federal Reserve Banks have been legally declared as private entities, the Board of Govenors which directs them is composed of seven Federal employees, whom are required to be independant of the banking sector.
↑↑ A very small amount of US money still exists as United States Treasury Notes, which differ from the money created by the Federal Reserve System. The official designation for the bills authorized by the Federal Reserve corporations are "Federal Reserve Notes."

Ramifications of the Economic Regulation Process
Occasional deficit spending is a requirement in a growing economy. The current economic process uses Treasury Securities which only exist when the nation is in debt. In 2005, the Federal Reserve held approximately 9% of the national debt in order to support the monetary base. Though gold was once the basis for the money supply, the government gradually transitioned away from precious metals and into the use of the National Debt as the economy's foundation. Experts are hopeful that other assets could take the place of National Debt as the fundamental basis, and Alan Greenspan, long the head of the Federal Reserve, has been quoted as saying, I am confident that U.S. financial markets, which are the most innovative and efficient in the world, can readily adapt to a paydown of Treasury debt by creating private alternatives with many of the attributes that market participants value in Treasury securities
There are costs associated with maintaining the money that is printed by the government. These costs arise in the form of the interest that US citizens are charged on the bank loans - loans which are required in order for money to be injected into the economy, and even simply for existing money to be maintained (as noted in "Step 8" in the above process). Note that in 2003, bank loans averaged an interest rate of 9%., which also closely matches the 9.84% average interest rate drawn from FDIC data spanning the 21 years from 1980 through 2001 .

By virtue of the economic process, more loans must be granted than are repaid every month in order to support the amount of US money in the world. If the total amount of loans were repaid to banks, then the supply of US dollars would be destroyed. While these are not secrets of the Federal Reserve System, these important steps appear to widely misunderstood, according to the volume of literature on topics such as "Federal Reserve conspiracy" and "Federal Reserve fraud."

An additional important ramification of this process is the fact that economic growth becomes coupled with debt, and this coupling is argued to create a social conflict, which may otherwise not exist.

Finally, the involvement of bank loans ties the economy to the problems of compounding interest. Many people theorize (including those at the Federal Reserve) that the amount of money is directly related to the value of each dollar . Thus, an exponential need for increasing amounts of money may be contributing factor towards inflation in the US. Inflation raises the cost-of-living for everyone, and if inflation exceeds the growth of income, then real wages decline.
The net effect is that citizens are effectively made poorer over time through no fault of their own.

Money supply, interest rates, and the economy
When interest rates go down, money supply increases. Businesses and consumers have a lower cost of capital and can increase spending and capital improvement projects. This is encourages growth. Conversely, when interest rates go up, the money supply falls and reins in the economy. The Federal reserve increases interest rates to combat inflation.

Criticism of monetary policy
Artificial Influences
Some free market economists, especially those belonging to the Austrian School criticise the very idea of monetary policy, believing that it distorts investment. In the free market interest rates will be set by saver's time preference. If there is a high time preference this means that savers will have a strong preference for consuming goods now rather than saving for them. Thus interest rates will rise due to the low supply of savings. With low time preference interest rates will fall. The interest rates send signals to businessmen as to what is worth investing in, low interest rates will mean that more capital is invested.

Monetary policy means that the interest rates no longer represent consumer time preferences and so investments are made by businessmen with the wrong signals. Lower than market interest rates will therefore mean a higher investment than the economy desires. This will mean that there will be capital goods that have been over invested, and will need to be liquidated. This liquidation is the cause of the depression that makes for the business cycle.

Lack of Accountability
There exists dispute about the accountability of this entire process. For example, one debunker goes through extensive arguments to show how well the system is audited and cites numerous instances of independent inspection by private accounting firms and the Government Accountability Office. This debunker's website then also lists the legal exemptions to outside audit. Exemptions to the Scope of GAO Audits The Government Accounting Office does not have complete access to all aspects of the Federal Reserve System. The (31 USCA §714) stipulates the following areas are to be excluded from GAO inspections: (2) deliberations, decisions, or actions on monetary policy matters, including discount window operations, reserves of member banks, securities credit, interest on deposits, open market operations; The same author also can be quoted in one related article as saying In terms of monetary policy, the most important power is ... open market operations. Additionally, one Federal Reserve detractor cites a particular newspaper article as providing more evidence about a lack of accountability within the system. ...in The Wall St. Journal Dec.10 '93 pB5B western edition and p A7B eastern edition. The title is: "Fed's Audit System Needs Big 'Revisions,'Inspector General Says" I won't quote the entire text but I'll quote enough to prove my point.
"The Federal Reserve's system for auditing its 12 reserve banks is too cozy and needs 'major revisions'
The problem...is that the Fed's Division of Reserve Bank Operations and Payments Systems is responsible both for the day-to-day oversight of reserve banks and for auditing them. This dual responsibility doesn't meet impartiality standards established by the American Institute of Certified Public Accountants, according to the Fed's inspector general, Brent Bowen. 'We believe there is an appearance of a lack of independence,' his report says. It proposes that the Fed either fully segregate the audit program or hire an outside auditor." The report cited in this article is from the horse's mouth, the Fed's own inspector general Brent Bowen, and clearly states that the Federal Reserve audits itself. There is no question that there have been audits, and much evidence exists to support the claims that the Federal Reserve is independently audited in some fashion; however, with legal exemptions applying to the primary mechanism that is used to move tremendous amounts of money through the economy, it remains unclear how comprehensive these audits have been. Nonetheless, in the end, many experts agree that insulation of monetary policy from political wrangling is in the best interest of the citizens, even despite the fact that the door may be left open to corruption.

Fulfilment of Goals
Another criticism is that exercise of monetary policy in the United States has not achieved consistent success in meeting the goals that have been delegated to the Federal Reserve System by Congress. Goals of Monetary Policy Sustainable growth, High employment, Stable prices
# High employment - The depression of the late 1920's is generally regarded as being the worst in the country's history and it occurred a significant time after the institution of the system along with some cycles of recession, which have caused a negative impact on employment levels during those times.
# Stable prices - While some economists would regard any consistent inflation as a sign of unstable prices, policymakers could be satisfied with 1 or 2%. As such, long-term price stability has not yet been achieved in nearly 100 years of operation under the Federal Reserve System↑↑. Historic inflation has averaged a 3.4% increase annually since the establishment of the Federal Reserve, along with numerous yearly swings of 10% or more. In contrast, some research indicates that average inflation for the 250 years before the system was near zero percent, though there were likely sharper upward and downward spikes in that timeframe as compared with more recent times.
# Sustainable growth - The growth of the economy may not be sustainable as the ability for households to save money has been on an overall decline and household debt is consistently rising. Overall, Americans are losing the battle to inflation, as indicated by the decline of real wages.

↑↑ Price stability as analyzed using historical CPI measures.

Public Confusion
The Federal Reserve has established a library of information on their websites, however, many experts have spoken about the general level of public confusion that still exists on the subject of the economy. John Maynard Keynes even said of an inflationary economic system that it "engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose." Critics of the Fed widely regard the system as being "opaque." one of the most vehement opponents, Congressman Louis T. McFadden, even went so far as to say that "Every effort has been made by the Federal Reserve Board to conceal its powers..." There are, on the other hand, many economists who support the need for the Federal Reserve corporations, and some have established websites that aim to clear up confusion about the economy. The Federal Reserve website itself even has a Q&A feature that lets visitors pose questions to "Dr. Econ."

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