Federal Reserve Monetary Policy - Thesis Proposal Example

US has officially entered into recession by the end of 2007 and it also resulted into an increased support from the government in the form of equity injection from the government. In order to save the financial system, government injected new funds while at the same time also executed an expansionary monetary policy by cutting interest rates and increasing money supply. However, due to persistent higher inflation in commodities which is invariably resulting into higher inflation for food inflation is increasing the overall costs for the consumers. Higher level of inflation is also resulting into eroding of the economic growth thus creating negative pressures on the economy. The overall debt position in US is also increasing thus making US Dollar as a less favorable global currency making it more difficult to make it preferred currency for conducting the global trade. All these factors therefore may render the effectiveness of the monetary policy as null and monetary policy alone may not result into desired results. Introduction US is going through the recovery phase of its business cycle after emerging from one of the worst economic crisis of modern history. What started as the subprime mortgage crisis soon emerged as a full fledge economic recession hampering almost all sectors of the economy besides resulting into depressed growth for the economy. The resulting collapse of the institutions therefore prompted government and federal reserve board to intervene into the economy and devise policies and procedures which could actually allow the US economy to resurrect on its own. Government injected money into different institutions in order to ensure that the liquidity position of the firms remain good while at the same time ensuring that the capital base of financial institutions is strong enough to sustain the losses. On the other hand, FED has also undertaken different policies in order to stimulate the economy while at the same time ensuring that the adequate aggregate demand is maintained in the economy. As a result of this, FED undertook steps such as slashing of the interest rates and quantitative easing as well as other measures to ensure that the economy is put back on track. However, these efforts may actually prove as detrimental for the overall growth prospects of the economy. This could be for number of reasons including commodity inflation which could result into higher core and headline inflation, inflation may be inevitable due to low interest rates thus effectively eroding the growth, higher debt burdens as well as the monetary expansion policy therefore may not serve the purpose. This paper will attempt to argue and discuss that the current policies of Federal Reserve may deter the economic growth in US. Commodity Inflation It has been argued that the correlation between the prices of different commodities is increasing over the period of time. Higher level of correlation between the prices of different commodities therefore suggests that the prices are interlinked and an increase in the prices of one commodity could lead to a chain event of increasing the overall price increase for other commodities. Stronger positive correlation between the prices of the commodities therefore suggest there are different factors which are effectively affecting the dynamics of different commodity markets and are creating a unifying impact on the market. (Derby) Commodities often serve as the input for the final goods and services therefore higher demand from the emerging economies such as China and India has actually fuelled the commodity prices also. Higher commodity prices therefore are resulting into higher prices for the finished products and therefore causing the inflation in the core and headline inflation also. It’s also because of this reason that food inflation is also increasing along with affecting inflation in other goods. (Calvo) Fed has adapted an inflationary monetary policy thus further fuelling the chances of having higher inflation. Higher inflation therefore can effectively erode the growth made by the economy and can result into the negative or low growth in real terms. The low real growth therefore can further deter the economy rather than supporting it. Inflation is inevitable Fed has adapted a policy of expansionary monetary policy under which the interest rates are kept at low whereas through quantitative easing, money supply has been kept at artificially high level. Higher money supply often results into the higher inflation due to neutrality of money the expansionary monetary policy could only result into higher inflation. FED has reduced the interest rates to the level of almost zero thus creating an environment where getting consumer credit has become easy. However, low interest rates often also result into high inflation if interest rates are persistently kept at lower level. In February 2011, US has recorded an inflation level of 2.1%1 which is relatively on higher level considering the fact that regions like EU has kept the inflation targets at 2%. It is critical to note that the jump to the inflation rate of 2.1% during 2011 was from 1.6% which was recorded during first month of 2011. Such higher level of increase in the inflation rates therefore could consistently undermine the growth prospects of the economy. Economic theory suggests that the higher level of consistent inflation could undermine the performance of the economy. Considering the existing policies of Fed, higher level of inflation may be inevitable in US and thus further undermining the growth prospects of the economy. The current policies therefore could further deter the economy and the policies may further dampen the economic growth rather than creating the desired level of stimulus for the economy. Debt Burden in the economy Due to the current economic crisis, US government has to inject fresh funds into the economy under its economic stimulus program. Heavy investments and funding were made to the financial and other institutions in order to keep them alive and ensure that the system as such does not collapse. What is however, significant to note that the higher level of injections from the government has also resulted into heavy borrowings because government may not have been in position to impose new taxes in the midst of one of the largest economic recessions in the history of the country? US public debt is almost 97% of its last year’s GDP thus making US as the 12th largest economy in the world having such huge debt. Higher level of debt therefore not only increases the deficit level in the economy but can also make the currency as less desirable. (Rogers). Higher debt by the US can render US dollar as a less desirable global reserve currency because of the lower interest rates. Lower interest rates coupled with the higher level of inflation can effectively deter the international investors to consider US Dollar as a preferred currency. It is also important to understand that higher domestic as well as international debt of US can also result into the higher crowding out effect thus reducing the availability of credit for private sector. Higher crowding out often drives money out of the reach of the private sector thus further reducing the solid chances of economic recovery. Monetary Policy alone is not sufficient Considering the higher inflationary pressures on the economy as well as the low interest rates and lesser attractiveness of US dollar as a preferred currency, the execution of expansionary monetary policy may not alone serve the purpose of the economic growth. Over the period of time, Fed has adapted the policy of expansionary monetary policy under which interest rates are kept at low and the money supply has been kept at artificially higher level. However, this has been done mostly without an expansionary fiscal policy under which government has not undertaken the fiscal policy at the same level of intensity as it has undertaken monetary policy. Though unemployment level is decreasing in the economy however, it has remained at the higher level in the recent past. Higher level of unemployment could have only reduced with the help of better executed fiscal policy under which the government has to undertake more active role in managing the economy and ensure that the necessary stimulus is provided to the economy through creating higher level of employment as well as cutting the taxes. It is also important to understand that the monetary policy as it is being executed in its current form may not result into the desired level of economic growth and could further deter the economy rather than allowing it to grow and come out of the recessionary pressures. It is critical that an effective fiscal policy is designed and executed too. Conclusion Over the period of time, FED has adapted an expansionary monetary policy which may not provide the desired results due to higher and persistent inflation in the economy. Higher inflation is also a direct result of the higher inflation in commodities which is invariably causing the increases in the core and headline inflation. It is also because of this reason that the inflation has become inevitable in the economy and may further damage the real economic growth in the economy. The current monetary policy as executed by the FED therefore can deter the economic growth rather than stimulating the economy. Bibliography Calvo, Guillermo. Exploding commodity prices, lax monetary policy, and sovereign wealth funds. June 2008. 04 April 2011 . Derby, Michael S. Fed’s Dudley: Unwise to Overreact to Commodity Inflation. 28 Feb 2011. 04 April 2011 . Rogers, Simon. US federal deficit: how much does China own of America's debt? 18 January 2011. 04 April 2011 . Read More

 

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