Federal Reserve System and Their Control on the US Money Supply - Term Paper Example

Federal Reserve System and Their Control on the US Money Supply Introduction There has been remarkable increase in the demand for US currency overseas in recent years and as a result the US bank notes have become one of the most widely recognized currencies in today’s world. Businesses and households abroad are increasingly turning to US dollars for their transaction and other needs, particularly at times of economic contraction (Lambert and Stanton, 2001, p. 569). This dramatic growth for the US bank notes has created challenges for the Federal Reserve in meeting the responsibilities of currency supply and distribution. This paper is an attempt to draw an overview of Federal Reserve and to detail how it controls the money supply in times of economic expansion and contraction. The paper presents a theoretical analysis on why it is important that a country’s central bank and regulatory system needs to have an adjustable money distribution. Federal Reserve: An overview The Central bank system of the United States is called Federal Reserve System which was created by the passage of the Federal Reserve Act 1913 (Knight, 2004) as an independent agency of the U.S government. Most of the large banks in the United States belong to the Federal Reserve System and they maintain banking-transaction relation, such as accounts, with Federal Reserve as is usually between an individual customer and his bank (Federal Reserve System, 2008). Both member and non-member banks are required to obey rules set by the Federal Reserve System related to the regulation of whole industry. Grey (2002) listed the major four duties of the Federal Reserve System. They are: 1) Conducting the monetary policy of the U.S by influencing money and credit conditions in pursuit of full employment, 2) Regulating and controlling banking institutions by ensuring the safety of banking and financial institutions, 3) Maintaining a stable financial system and 4) Providing certain financial services to the U.S government, to the general public, financial institutions and foreign official organizations (p. 9). Out of these four duties and responsibilities, controlling money supply through monetary policy remains to be the most important function that helps make effective monetary policy in order to keep a control on inflation and unemployment. The Fed’s (Federal Reserve System) actions, mainly controlling money supply and credit conditions, are most likely to affect the interest rates charged by banks on businesses and consumers and help keep inflation under control. The Fed is directing, shaping and conducting U.S monetary policy as a measure to achieve price stability and fuller employment. The Fed and its control on U.S money Supply Inflation is perhaps one of the most economic problems that countries worldwide experience in today’s complex macro-economic contexts. The size of the money supply directly affects all facets of the economy and it thus has a very close relation to the inflation as well. The primary duty of the Federal Reserve System is to monitor the macro-economic situations of the U.S and take appropriate decisions regarding whether the U.S dollar supply should be increased or decreased or left the same. The Fed is the supreme authority in the U.S to easily decide on the size of the money supply to be in place and to take it in to effect by influencing banks and their way of making loans. Before the emergence of Federal Reserve System in 1913, the currency circulation couldn’t accommodate shifts in demand due to the seasonal and cyclical factors in the times of financial crisis. The currency supply was until then limited. The Federal Reserve Act of 1913 brought provisions of elastic currency that would expand or contrast based on the public demand. The depository banks would be influenced to deposit currency with or order currency from the Federal Reserve Bank in order to meet the changes in the demand of the currency. The 12 branches of Federal Reserve Banks were located to facilitate the exchange of the currency as needed to the depository banks or from the them throughout the U.S (Lambert and Stanton, 2001, p. 569). Money supply is controlled mainly through monetary policy. The monitory policy is consisting of the directives, policies, pronouncements and actions that Federal Reserve has taken in order to affect aggregate demand or national spending (Labonte and Makinen, 2008). The monetary policy is related to the supply of money and it encompasses various activities of the U.S Treasury in relation to the foreign exchange operation. The most important function of the Federal Reserve system is carrying out monetary policy with the help of a body called Federal Open Market Committee (FOMC) that meets eight times in a year to take monetary policy decisions (Gitman and McDaniel, 2008, p. 412). The Federal Reserve has been playing vital role in preventing boom and bust cycles by regulating banks and other financial institutions, same time by ensuring the financial soundness of the financial institutions too (Guell, 2008, p 155). Various tools for Controlling Money The Federal Reserve system uses various tools and methods in order to keep a target which can be either a key interest rate, or a monetary aggregate or a measure of inflation. For instance, during 1970s, federal Reserve banks used ‘federal funds rate’ at which banks borrowed from one another to meet particular reserve requirements. When there is a constant down in the fund rate, then it would result in the increase of money supply. Inflation targeting is another tool which involves proclaiming a desired range of a specified inflationary measure and then using the monetary policy to bring that measure of inflation in to the desired rage. Open market operation is another tool for controlling the supply of money, which the Federal Reserve buys and sells government debts. The Federal reserve owns around half trillion dollars of the national debt and it sells a portion of it to get money out of the system (Guell, 2008, p 156). Economic Significance of Money Control and monetary policy Monetary policy helps bring changes in the money supply to influence the aggregate demand and GDP growth. At times of economic expansion or contraction, the changes brought in the money supply through monetary policy can have potential to bring further changes in the growth of GDP and employment as well. it may not be true in long run macro economic situation, because, increased money supply can significantly impacts the rate of inflation. An easier monetary policy causes a rightward shift in the money supply curve and lower the interest rates (e.g. from 8% to 10%). As a result of this, the investment spending will be increasing causing a rightward shift in the aggregate demand curve and also causing a reasonable increase in the output level from the recessionary state to the level of fuller employment (see figure above). In contrast, a tight monetary policy makes leftward shift in the money supply and aggregate demand curve as well (McConnel and Brue, 2004, p. 277). In order to increase the money supply, the Federal Reserve banks may buy government securities from banks and public from an open market, reduce the legal reserve ratio and reduce the discount rates. An increase in the money supply, for instance from 4100 billion to $130 billion will reduce the interest rate from 10 to 8 percent and as a result it will boost investment from $ 10 billion to $13 billion. The increase of $3 billion investment will effectively shift the aggregate demand curve to the right by more than the increase in the investment Conclusion This piece of research paper has presented an overview of Federal Reserve System and its way of controlling money distribution in the US and also to the world to meet the increasing demand for US dollars worldwide. The Federal Reserve System is the central bank in the US that directly influence the banks and control supply of money in the U.S. Through various tools like open market operation, federal funds rate and inflation targeting, the Fed is controlling the money supply, increasing or decreasing at times of economic expansions and contraction respectively. References Federal Reserve System, 2008, Everyday Finance: Economics, Personal Money Management, and Entrepreneurship. Vol. 1. Detroit: Gale, Gale Virtual Reference Library. Retrieved 26/09/10 from http://go.galegroup.com/ps/i.do?&id=GALE%7CCX2830600135&v=2.1&u=apollo&it=r&p=GVRL&sw=w Gitman L J and McDaniel C, 2008, The Future of Business: The Essentials, Illustrated fourth edition, Cengage Learning Grey G B, 2002, Federal Reserve System: background, analyses and bibliography, Illustrated edition, Nova Publishers Guell R C, 2008, Issues in Economics Today, Fourth Edition, McGraw Hill Companies, Irwin, Knight J, 2004, Federal Reserve System, United States. Encyclopedia of Espionage, Intelligence and Security. Ed. K. Lee Lerner and Brenda Wilmoth Lerner. Vol. 2. Detroit: Gale, 12-14. Gale Virtual Reference Library. Retrieved from http://go.galegroup.com/ps/i.do?&id=GALE%7CCX3403300301&v=2.1&u=apollo&it=r&p=GVRL&sw=w Labonte M and Makinen G E, 2008, Monetary Policy and the Federal Reserve: Current Policy and Conditions, CRS Report for Congress, Congressional research Service Lambert M L and Stanton K D, 2001, Opportunities and Challenges of the U.S Dollar as an increasingly Global Currency: A Federal Reserve Perspective, Federal Reserve Bulletin McConnel C R and Brue S L, 2004, Economics, Principles, Problems and Policies, Sixteenth edition, McGraw Hill Irwin Read More