Creating Your Own Monetary Policy - Research Paper Example

Monetary Policy: Monetary policy refers to a series of actions that the United s Federal reserve undertakes for purposes of influencing the availability of credit and cost of money, for purposes of promoting national economic growth. The 1913 Federal Reserve Act allows the Federal Reserve to create a monetary policy. There are three important tools of monetary policy, and they are, the reserve requirements, the discount rate, and the open market operations (Orphanides and Volker, 17). The discount rate refers to the amount of interest that the Federal Reserve charges to commercial banks and other financial depository institutions for the various loans that they acquire from the discount window of the Federal Reserve. The reserve requirements can also be referred to as the reserve cash ratio. This is a requirement that banking institutions need to deposit a certain amount of money to the Federal Reserve against the various deposits that is made by their respective customers. Open markets operations on the other hand involve the processes of the country’s central bank to sale and buy government bonds in an open market (Orphanides and Volker, 27). The main aim of using this tool as a monetary policy is to manipulate the supply base of money within an economy, and the short term interest rates, for purposes of controlling the nature and level of money supply within an economy. This paper develops a monetary policy that differs from the last policy statement issue by the FOMC. The last policy statement by FOMC was released on 30th of October 2013. Under this policy statement, FOMC denotes that it will continue with its asset purchasing programs. This is because the committee had noted that the policy gained efficiency in improving the economic activities of the United States of America. The committee also has plans to adjust the pace of its asset purchases, but it is still waiting for a report on the levels of progress that the current pace in asset purchasing has an influence in the American economy (Press Releas, 2). According to this policy statement, FOMC made a decision to continue with the purchase of additional mortgages that are backed with securities. This is at a price of $ 40 billion every month. The FOMC also decided to buy long term financial securities at an amount of $ 45 billion every month. Under this policy statement, the FOMC decided to maintain its policies of re-investing principal payments (Press Release, nd. 3). These principal payments emanate from its various holdings of the agency debts and mortgage backed securities. The FOMC also decided to sale matured treasury securities through an auction method. By implementing these policies, the FOMC believes that they would manage to maintain and achieve a down ward pressure on long-term interest rates. The FOMC also believes that they will manage to support the mortgage market, helping to create a broad financial condition that is more accommodative to the various economic and financial interests within an economy. On this note therefore, the FOMC decided to continue with its purchases of mortgage backed securities. This will in turn lead to the growth and development of the economy under consideration. For effective implementation of these policies, the FOMC decided to closely monitor all information concerning the financial and economic development of the country. The monetary policies identified by FOMC do not solve the problem of liquidity. Liquidity is a Macro economics issue that refers to the extent in which a security or an asset can be sold or bought without having an effect on the price of the particular asset. One major characteristic of liquidity is the high number of trading that the asset under consideration attracts. Examples of assets which are highly liquid include securities of money market. During the 2007 credit crunch, it was very difficult for people to access funds such as loans (Orphanides and Volker, 33). Due to the difficulties of accessing credit, then chances are high that the economy might fail to grow. On this basis, there is always a need of increasing the liquidity of a state. Through this increase, chances are high that economic agents might be able to access credit, and hence lead to the development and growth of the economy under consideration. The identified monetary policies of FOMC do not address this problem of liquidity (Ray, 28). In my own opinion, for purposes of increasing liquidity, curbing inflation and improving the economy of the United States, the FOMC should adapt the use of term auction facility. This policy was successfully used by the Federal government in 2007 as a response to the sub-prime crises that hit the United States of America (Ray, 28). This is after the failure of the Federal government policy to increase liquidity through a reduction of its discount rate. Under this policy, the Federal Reserve will embark on a bid to auction a given amount of short term loans which are collaterally backed (Orphanides and Volker, 22). These loans are auctioned to depository institutions which are financially stable, and evidence of their financial capability is given by their reserve banks. Under this instrument of monetary policy, depository institutions will make a bid for these short term loans through their reserve banks. In choosing a minimum bid, an index swap that relates to the maturity of the loan is carried out during the night (Ray, 28). Through this auction method, a financial institution gains the capability of borrowing money at a cheaper rate that is way below the discount rate. On this basis, the Federal government will succeed in increasing liquidity within the economy, therefore preventing an occurrence of liquidity crises (Orphanides and Volker, 31). Liquidity crisis refers to a notion whereby the cash resources of an economy are in a very limited supply, and the demand on the other hand is high. Other sources of liquidity for an economy include earnings from exports, direct foreign investments, and remittances from their citizens working abroad. Solving this liquidity crisis through the use of term auction facility will lead to an increase of higher interest rates charged on credit, and thus there will be an ease in obtaining loans from banking institutions. This concept can easily be represented by the use of a yield curve (Ray, 28). A yield curve is referred to as a graphic representation of the short and long term interests of bonds and financial securities issued by the government. In order to fix the short term interest rates, monetary policies are the best tools of solving the problem. The rates of the long term interest on the other hand are determined by the market under consideration (Ray, 48). A yield curve has three major shapes, and each shape identifies a particular situation. An upward sloping yield curve indicates that the interest rate of a long term loan/ bond is above the interest rates of a short term loan/ bond. On this basis, there is an expectation of a rise in the short term interest rates of a government bond or a loan. Ray (33) denotes that an inverted yield curve is a symbol that the economy is not performing well, and hence, there is a drop of the interest rates. Ray (34) further believes that a flat a flat yield curve is a symbol of an increase in the interest rates of the long term and short term loans. The following is a data on the interest rates, and the subsequent yield curve for the year of 2013 (Resource Center n.d, 03); Date One month Three months Six Months one year Two years Three years Five years Seven years Ten years Twenty years Thirty years Dec 2nd 2013 0.02 0.05 0.10 0.13 0.30 0.59 1.43 2.19 2.81 3.58 3.86 Dec 3rd 2013 0.04 0.06 0.10 0.13 0.28 0.58 1.40 2.93 2.79 3.56 3.84 Dec 4th 2013 0.04 0.06 0.10 0.13 0.30 0.60 1.45 2.19 2.84 3.63 3.90 Dec 5th 2013 0.02 0.06 0.10 0.13 0.30 0.61 1.49 2.23 2.88 3.65 3.92 Dec 6th 2013 0.03 0.06 0.10 0.13 0.30 0.64 1.51 2.23 2.88 3.63 3.90 Dec 9th 2013 0.04 0.07 0.10 0.13 0.30 0.64 1.51 2.23 2.86 3.61 3.88 Dec 10th 2013 0.03 0.07 0.10 0.14 0.30 0.62 1.46 2.17 2.81 3.56 3.83 By looking at this curve, we can denote that it is an upward sloping yield curve. An upward sloping yield curve indicates that the economy is recovering from recession, and there is availability of credit. On this note, this yield curve denotes that the American economy is expecting a rise in the interest rates of its securities, bonds and loans. The term auction policy will therefore help in accelerating the rise of interest rates, through promotion of liquidity. It is important to denote that the main aim of the term auction policy is to increase monetary liquidity into the economy (Ray, 36). This is by auctioning the short term loans at a lower interest, for the main purposes of encouraging the flow of money within an economy. In the long run, this policy might lead to an increase in the interest rates of a country’s economy. In conclusion, this paper manages to effectively define the concept of monetary policy. From the discussion of this paper, we can denote that monetary policy is a series of actions that a government initiates for purposes of influencing the availability of credit. The FOMC is the body that has the responsibility of initiating a monetary policy, and it normally issues press briefings on the policies that it seeks to pursue. This paper proposes a monetary policy that can help the government to increase liquidity in its economy. The policy under consideration is the term auction policy. Works Cited: Orphanides, Athanasios, and Volker Wieland. Complexity and Monetary Policy. London: Centre for Economic Policy Research, 2012. Print. "Press Release." FRB: --Federal Reserve issues FOMC statement--October 30, 2013. N.p., n.d. Web. 10 Dec. 2013. . Ray, Partha. Monetary policy. 1. ed. New Delhi: Oxford University Press, 2013. Print. "Resource Center." Daily Treasury Yield Curve Rates. N.p., n.d. Web. 8 Dec. 2013. . Read More