The United States federal monetary policy is controlled by the Federal Reserve System (Fed). The goal of the Fed is to decrease inflation, and it has several tools at its disposal to do so.

  1. Reserve Requirement
  2. Discount Rate
  3. Open Market Transactions
It is obvious that the object of a reserve bank is not just to reduce inflation. That would be the easiest thing to achieve. All the bank would have to do would be to influence the expected rate of inflation. This can be done through a sustained monetary contraction.

Usually a central bank aims to maximise employment as well, through indirect means. This can be done through a sustained monetary expansion.

The reason why a sustained monetary expansion creates low unemployment is simple. Follow this reasoning:

First assume a closed economy.

Assume that the rate of monetary growth, m, the rate of inflation, p, and the expected rate of inflation, p(e), are all zero. If the expected rate of inflation and the rate of inflation are equal, this implies that the rate of unemployment is at the natural rate, or the rate at which all people can find jobs, and the only people out of work are the people in between jobs. This also implies that the economy's resources are closed to being fully utilised.

Now, imagine that the government moves money supply growth, m, to a positive rate, and that this rate will stay the same forever. This growth in the money supply will create excess demand in the economy, and because resources are close to full capacity and full employment, producers will seek to increase their prices since the cannot increase production. This leads to a positive p, rate of inflation.

This higher price level will lead producers to believe that an expansion of output will lead to greater profits, and they offer higher wages.

Now suppose the general public, being unaware of the exact nature of inflation at the time, expects inflation to be the same as the last period, before the monetary expansion. Their perception of the real wage (wage/price level) is now deceptive, they will think that the real wage is GREATER than its actual value. They are fooled into thinking that they are better of because of higher wages.

The net result is higher nominal wages, higher inflation, lower unemployment.

The questions that monetary policy seeks to address are about unemployment, the rate of inflation, exchange rates and how the affect the economy, and ultimately about the level of living standards that you or I have.

People may think it's boring, but its every act is like a giant's hammer, pounding into countries and our lives.

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