Answer to Question #49292 in Macroeconomics for Raquel Aracena

Question

The US economy often encounters twin problems of unemployment and inflation. Suggest instruments often used to resolve these problems and which GDP component is targeted

Answer 1

Monetary policy tries to control over the money supply and interest rates by a central bank or monetary authority to stabilize business cycles, reduce unemployment and inflation, and promote economic growth. In the United States monetary policy is undertaken by the Federal Reserve System (the Fed). In principle, Federal Reserve policy makers can use three different tools--open market operations, the discount rate, and reserve requirements--to manipulate the money supply. In practice, however, the primary tool employed is open market operations. An alternative to monetary policy is fiscal policy.

Monetary policy is controlling of the quantity of money in circulation for the expressed purpose of stabilizing the business cycle and reducing the problems of unemployment and inflation. In days gone by, monetary policy was undertaken by printing more or less paper currency. In modern economies, monetary policy is undertaken by controlling the money creation process performed through fractional-reserve banking. The Federal Reserve System (or the Fed) is U.S. monetary authority responsible for monetary policy. In theory, it can control the fractional-banking money creation process and the money supply through open market operations, the discount rate, and reserve requirements. In practice, the Fed primarily uses open market operations, the buying and selling of U.S. Treasury securities, for this control.

An important side effect of money supply control is control of interest rates. As the quantity of money changes, banks are willing to make loans at higher or lower interest rates.