The Monetary Behavior as Created by the Federal Reserve - Essay Example

?To understand the role of the Federal Reserve, it is necessary, first and foremost, to talk about that which the Federal Reserve exercises power andcontrol over: the United States dollar. It is also important to understand that the dollar is not backed by anything other than the paper on which it is printed (Rothbard, 1994). First printed as “greenbacks” to finance the Civil War in the 1860s, the paper currency that the United States uses today was, at first, backed by precious metals such as gold and silver, with a distinct standard of worth to hold it to (Rothbard, 1994). However, that standard has since been done away with, and the dollar now, such as it is, is nothing more than printed paper until it is exchanged for something of value, whether that is goods or services (Rothbard, 1994). Though it is backed by the US government and considered a “Federal Reserve Note”, it comes as a shock to most that the currency that drives our society today, both in the United States and worldwide, is essentially worthless if it were to stand alone. Founded by Congress, the Federal Reserve was created to provide the nation with a safer, more flexible, and more stable monetary system (Federal Reserve Publications Committee, 2005). The structure of the Federal Reserve itself was designed to give a broad outlook on the economy and economic matters, and more importantly, bring some stability to a currency that had greatly fluctuated in value between the time when the states had gained independence and 1913 (Federal Reserve Publications Committee, 2005). Among other tasks, the Federal Reserve was also responsible for providing the Federal Open Market Committee (FOMC), which today is tasked with setting the monetary policy for the United States and ensuring that the monetary policy that is set completes the goals of providing for maximum employment, stable prices, and moderate long-term interest rates (Federal Reserve Publications Committee, 2005). Theoretically, with the Federal Reserve behind the pieces of paper that we value as currency, and with so many safeguards in place, the dollar should always be worth what it says it is; one dollar should equal one dollar, without question. But one dollar does not always equal one dollar. In fact, in some instances, the value can be significantly higher, or even lower, than the dollar amount denoted on the paper, all due to the acts of the Federal Reserve. The Federal Reserve also has the responsibility for the behavior of the dollar on the global exchange market, alongside the bigger picture of controlling how much currency is printed and in circulation at any one time (Federal Reserve Publications Committee, 2005). Any action taken by the Federal Reserve in regards to these factors can in some way, shape, or form, influence and controls the behavior of the US dollar. The Federal Reserve has the power, and has always had the power since its creation, to control the amount of funds in its regional banks throughout the United States. By the Federal Reserve requiring any Federal Reserve banks to keep reserves on hand to handle unexpected outflows as well as meet the demands for the daily operations, it was believed that stability in the behavior and value of a dollar would result (Federal Reserve Bank of San Francisco). These reserves, however, also play an important part in how the Federal Reserve controls the behavior of a US dollar throughout the nation and the world. From day to day, the amount of reserves a bank wants to hold may change in accordance with its daily transactions. Therefore, when a bank finds that it needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need (Federal Reserve Bank of San Francisco). The interest rate associated with this overnight borrowing of reserves is called the federal funds rate, which adjusts to balance the supply of and demand for reserves. The U.S. Federal Open Market Committee (FOMC) sets a target for the federal funds rate, and keeps the rate on target by increasing and decreasing bank reserves through transactions such as the buying and selling of U.S. Treasuries (Federal Reserve, 2011). This is all done in accordance with the long-term goals of monetary policy as stated above. For example, if the Federal Reserve wants the federal funds rate to fall, it buys government securities from a bank, and then pays for the securities by increasing the reserves held at that bank (Federal Reserve Bank of San Francisco). As a result, the bank now has more reserves than it wants, and the federal funds rate falls (Federal Reserve Bank of San Francisco). If the Federal Reserve wished to do the opposite, it would have instead sold government securities. This would have caused the federal funds rate to rise, and lower the supply of reserves in the banking system (Federal Reserve Bank of San Francisco). The federal funds rate, in this way, acts as the major instrument of how the Federal Reserve maintains indirect control over the interest rates of the nation, as well as its impact on the dollar. The federal funds rate target is used as the target by banks to determine their “prime rate”, the base interest rate at which banks will lend money to their customers. Although the Federal Reserve has no direct role in setting the prime rate, many banks choose to set their prime rates based partly on the target level of the federal funds rate, and increase the interest rates to customers based on factors such as credit history and credit risk (Federal Reserve, 2011). Changes in the interest rates, and thus the behavior of the US dollar, have consequences that can ripple throughout the nation, which are not all negative. The reduction in value of a dollar associated with a drop in interest rates by the Federal Reserve can potentially stimulate the national economy, since consumers are always looking for ways to borrow money without having to suffer a higher interest rate (Federal Reserve Bank of San Francisco). When the Federal Reserve lowers the federal funds rate target, causing banks to lower the prime rate and succeeding interest rates, though it devalues the dollar it also makes borrowing attractive to consumers, which can potentially lead to a round of loans from banks to consumers. Unfortunately, though the Federal Reserve does its best to control the interest rates of the United States through the federal funds rate target, the dollar does not always behave as the Federal Reserve predicts that it should. A good example of this is in the fact that the Federal Reserve has attempted since the housing market “crash” of 2007 to stimulate the economy by keeping the interest rate at or near zero; what it failed to take into account, however, was that fact that the crash also precipitated a “credit crunch”, as all financial institutions started hoarding cash (Blackburn, 2008). Therefore, keeping the interest rate low has not had much of an effect on the stagnant economy or the dollar, the value of which crashed alongside the housing market. In theory, the economy should have been stimulated, but in reality, the predicted behavior of the dollar failed to meet the reality of the situation. Any decisions that are made by the Federal Reserve that affect the interest rate also affect the rate and behavior of the US dollar on the foreign exchange market, or in other words, how the dollar is valued globally in relation to the currencies of other countries (Federal Reserve Bank of San Francisco). In the short-term, higher interest rates mean more profit for investors, so raising the interest rate will generally make the dollar look stronger, and more attractive, to foreign investors (“50 factors that”, 2007). Investors in the US dollar will buy more, as they will make more profit, and therefore the value of the dollar will strengthen and go up. Yields on dollar assets will look more favorable, and lead to a bidding up of the dollar on foreign exchange markets (Federal Reserve Publications Committee, 2005). However, lowering the interest rate can have the opposite effect, since investors will then sell their investments and drop the dollar because there is not enough profit in it to make it worth investing in (“50 factors that”, 2007). Going back to the principle of interest rates and their effect on the US dollar, high interest rates can attract foreign investors looking for high-yield returns on their investments, which cause more demand for the dollar, which increases its value. Eventually, the increased value of the dollar will ultimately slow foreign investment, since it takes more foreign currency to purchase a dollar (“50 factors that”, 2007). According to the Wealth Cycle Principle, a popular blog dealing with the subject of money, the Federal Reserve has extraordinary power over the global economy because of the U.S. dollar’s privileged “reserve status”. Foreign institutions like central banks and foreign treasuries, and even global markets like gold and oil, hold the majority of their assets in U.S. dollars. On the global market, several currencies are actually “pegged” to the dollar, that is, their currency value is fixed to the value of the dollar (“Fixed currency regimes”). An example of this is the Saudi Riyal, which is pegged at 3.75 USD to 1 SAR (riyal) (“Fixed currency regimes”.) It stands to reason, then, that when the dollar fluctuates, the value of the riyal in terms of exchanging dollars for it will fluctuate as well. As if controlling federal funds rates and keeping an eye on interest rates, as well as being responsible for monetary policy were not enough of a job description, the Federal Reserve also must keep watch over the “bigger picture” of the US Dollar, which is to say how many of them there are in circulation. Though it is hard to believe, printing more currency leads to a decline in its value, because each one printed is of less value than the one before it, as the supply has now been increased (“50 factors that”, 2007). This is one way in which the dollar is highly predictable, as more dollars leads to less value for each one. In practice, this almost always directly causes inflation, which then directly eats into the value of the dollar even more (“50 factors that”, 2007). The Federal Reserve, therefore, must exercise cautious control over its buying and selling of government securities, as they affect not only the federal funds rate targets but also the amount of money that circulates throughout the country. The Federal Reserve, without a doubt, holds a prestigious and yet possibly the most unenviable place in not only United States but global finance and economics. The central bank and the FOMC must be part fortune teller, part economist, part rescue worker, and part physicist. They must watch the economy and make judgments and predictions based on data, which may or may not come true. They must look at the global market and determine how to best exercise control over the interest rates through their actions, so that the dollar retains value to other countries. They must rescue banks if there is a panic with financial reserves and maintain a careful eye on the number of dollars in circulation. Finally, and possibly most importantly, they must remember the principle of every action having some sort of reaction, as the actions of the Federal Reserve tend to affect larger numbers of dollars and therefore have larger reactions and consequences on the economy of both the nation and the world. There is also no doubt that the Federal Reserve holds the greatest impact on the behavior of the United States dollar. In their every action and prediction, the dollar will either rise or fall. Like a hyperactive small child, the Federal Reserve must attempt to exercise some control over its behavior through regulation and setting limits, in the small hope of keeping the growth of the United States on a steady pace. In regulating the value of the dollar, the Federal Reserve attempts to avoid more costly consequences, such as quite possibly the dollar becoming worthless with no options of recovery on the open market to anyone, whether they are consumer or investor. Though some of these actions may take place as part of a charted, set movement by the Federal Reserve and FOMC, in accordance with the goals of monetary policy, it cannot be denied that the dollar, like a small child, can have a mind of its own and do what it wants, including the exact opposite of any predictions, no matter how sound they might seem. Therefore, though the Federal Reserve does control a great part of the behavior of the US dollar through its actions of lowering and raising the federal funds rate target, the blame cannot be entirely laid at its doorstep, as too many key factors of not only the United States but other countries must be taken into account. References 50 factors that affect the value of the u.s. dollar. (2007, August 8). Retrieved from http://www.currencytrading.net/features/50-factors-that-affect-the-value-of-the-us-dollar/ Beller, M. D. (2011, June 30). Greenspan: fed's massive stimulus had little impact. Retrieved from http://www.cnbc.com/id/43598606 Blackburn, R. (2008, March 30). The subprime crisis. The New Left Wing Review, (50), 63-106. Retrieved from http://www.newleftreview.org/?view=2715 Federal Reserve. (2011, August 2). What is the prime rate?. Retrieved from http://www.federalreserve.gov/faqs/credit_12846.htm Federal Reserve Bank of San Francisco. (n.d.). About the fed. Retrieved from http://www.frbsf.org/publications/federalreserve/monetary/tools.html Federal Reserve Publications Committee. U.S. Department of Treasury, Federal Reserve System. (2005). The federal reserve system: purposes and functions. Washington, D.C.: Publications Fulfillment. Retrieved from http://www.federalreserve.gov/pf/pdf/pf_complete.pdf Fixed currency regimes:exploiting pegged currencies for profit. (n.d.). Retrieved from http://www.forexfraud.com/forex-articles/pegged-currencies.html Maloney, M. (2010, September 20). How the fed controls the world [Web log message]. Retrieved from http://wealthcycles.com/blog/2010/09/20/how-fed-controls-world Rothbard, M. R. (1994). The case against the fed. Auburn, Alabama: Ludwig von Mises Institute.Retrieved from http://mises.org/books/fed.pdf Read More