Monetary policy of the USA
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The Federal Reserve implements monetary policy by manipulating the money supply.
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How is money created
When money is deposited in a bank it can then be loaned out to another person. If the inital deposit was $100 and the bank loans out $100 to another customer the money supply has increased by $100. However, because the depositer 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 only loan out $90 and thus the money supply increases only to $190. This relationship between increase in money supply and reserve requirement is expressed as:
m = 1 / RR
where
m = money multiplier RR = reserve requirement
Federal Reserve and Money Supply
The Federal Reserve has two main mechanisms for manipulating the money supply. It can sell treasury securities. When it sells treasury securities it reduces the money supply (because it accepts money in return for a promise to pay in the future). It can purchase treasury securities. When it purchases treasury securities it increases the money supply. Finally, the Federal Reserve can adjust the reserve requirement. The reserve requirement is indirectly related to the money multiplier as show above.
Money Supply, Interest rates and the Economy
When the interest rates go down, money supply increases. When interest rates go down businesses and consumers have lower cost of capital and can increase spending and capital improvement projects. This helps the economy. Conversely, when the 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
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.