The Federal Open Market Committee - Coursework Example

? The Federal Reserve The Federal Open Market Committee The Central Bank of a country has the power to influence the supply and value of money and credit in the economy to achieve certain economic objectives. The Central Bank undertakes certain actions for this purpose and this implementation is called the “Monetary Policy”. The Federal Reserve Act of 1913 empowers the Federal Reserve Bank of U.S.A to implement the Monetary Policy in the country. (Board of Governors of the Federal Reserve System, 2011) The Federal Reserve controls the monetary policy through mainly three policy instruments: open market operations, the discount rate and reserve requirements. The depository institutions of the economy hold some balances with the Federal Reserve Bank. The depository institutions also lend balances at the Federal Reserve to other such institutions overnight. The interest rate at which these balances are lent is known as the federal funds rate. The Federal Reserve, with the help of its three policy instruments, influences the demand and supply of these balances held by the depository institutions at the Federal Reserve and thus also changes the federal funds rate. As the federal funds rate changes, this starts a sequence of activities which influences other short term interest rates, long term interest rates, foreign exchange rates, amount of money and credit circulating in the economy, employment, output, the prices of goods and services and many other economic variables. (Board of Governors of the Federal Reserve System, 2011) The Three Main Tools of Monetary Policy Open Market Operations: Under the open market operations, the Federal Reserve Bank buys and sells U.S Treasury bills and federal agency securities in the market. These operations are usually conducted to achieve a desired level of balance reserves which the depository institutions hold with the Federal Reserve. The operations can be conducted to achieve a desired value of the federal funds rate too. Usually, the short-term objectives of the open market operations are specified by the Federal Open Market Committee. The new securities issued in the market by the State Government from January–July 2011 can be tabulated as follows: (Board of Governors of the Federal Reserve System, 2011) (Board of Governors of the Federal Reserve System, 2011) The Discount Rate: The Federal Reserve Bank has its branches located in the different regions of USA. These regional Reserve Banks have a lending facility called the discount window through which they extend loans to the commercial banks and other depository institutions of that region. The interest rate charged on these loans is the discount rate. The Federal Reserve Banks offer three types of loans through their discount windows: primary credit, secondary credit and seasonal credit, extended at their respective discount rates. The primary credit discount rate is stipulated above the short-term market interest rate level. The secondary credit discount rate is set above the primary discount rate. The seasonal credit discount rate is determined by calculating an average of selected market interest rates. The regional Reserve Bank’s Board of Directors determines their respective discount rates, although they remain to the review of Board of Governors of the central Federal Reserve Bank. The funds borrowed by the Commercial Banks from the Federal Reserve Bank from January- July 2011 can be seen from the following table: (Board of Governors of the Federal Reserve System, 2011) (Board of Governors of the Federal Reserve System, 2011) Reserve Requirements: The Federal Reserve Bank stipulates an amount of funds that the depository agents should keep as reserves against specific amount of deposit liabilities. These are known as reserve requirements. The depository institutions usually hold these reserve requirements in the form of deposits or vault cash with the Federal Reserve Bank. Only the Board of Governors of the Federal Reserve Bank holds the power to change the reserve requirements. (Board of Governors of the Federal Reserve System, 2011) The Reserve Balances of the Commercial Banks which they kept as Reserve Requirements with the Federal Reserve during January-July 2011 can be tabulated as follows: (Board of Governors of the Federal Reserve System, 2011) The Effects of Monetary Policy on Gross Domestic Product The Gross Domestic Product (GDP) of a country is the total value of all final commodities and services produced in the country in a specific year. It is equal to the sum of the consumer, investment and government spending plus exports minus imports. This can be represented by an equation GDP = C + I + G + (X – M)… (1) where C: Consumption spending I: Investment spending G: Government spending X: Value of Exports M: Value of Imports The Federal Reserve Bank uses the instruments of monetary policy to influence the different economic variables in the economy. Such implementations can result in either expansionary activity or contractionary activity in the market. Expansionary Activity: The Federal Reserve can increase the money supply in the economy by three methods: buying securities in the open market, decreasing the discount rate and lowering the ratio of reserve requirement. All other variables held constant, when the Fed buys securities in the open market, it pays money to the commercial banks in exchange of the securities and thus the bank reserves increase. Similarly, when the Fed lowers the reserve requirements, the commercial banks have to hold lower amount of funds as reserves with the Fed and thus the commercial banks’ reserves increase. In both these cases, as the bank reserves increase, the bank deposits go up and so does the money supply. As the money supply increases in the money market, the interest rate falls and the prices of securities begin to rise. Again, keeping all other variables constant, when the Fed decreases the discount rate, this usually lowers the interest rates in the economy. At low interest rates, the economic agents in the market are encouraged to borrow loans from the commercial banks. When the agents get such cheap funds from the banks at their disposal, they start spending more. Householders increase their consumption expenditure on automobiles, appliances etc. In equation (1), C rises. Similarly, the investment expenditure made by householders, businesses and governments on fixed assets (housing, equipments etc) increases. Thus, in equation (1), ‘I’ also increases. The State and local governments also begin to spend more on building new infrastructure. Thus in equation (1) G also rises. Again, as the interest rate falls relative to foreign rates, this will result in a decrease in the dollar’s value when compared to other currencies of the world. As the foreign exchange value of dollar falls, the U.S goods become cheaper compared to foreign goods in the world market. Thus exports from the USA increase. Thus in equation (1), X also rises. In eqn (1), GDP = C + I + G + (X – M), following an expansionary monetary policy, C, I, G and X all increase. Therefore, the GDP of the nation also increases. The expansionary policy of the Federal Reserve causes all the economic agents to increase their spending which in turn increases the GDP. This causes an increase in the real output level and a rise in employment in the economy. As a result, inflation rates may rise in this case. Ideally, the Federal Reserve desires to implement an expansionary monetary policy that would result in economic expansion, without price inflation (Saunders & Cornett 2007, p 114). The index of industrial production recorded during February-July 2011 can be seen from the table as follows: Month Index of Industrial Production (IIP) Feb 2011 92.5 Mar 2011 93.1 Apr 2011 92.8 May 2011 93 Jun 2011 93.3 Jul 2011 94.2 (Board of Governors of the Federal Reserve System, 2011) Contractionary Activities: The Federal Reserve can also implement a contractionary monetary policy with the help of the same policy instruments: by selling securities in the open market, increasing the discount rate and also increasing the ratio of reserve requirement. With all other variables remaining constant, when the Fed sells securities in the open market, the commercial banks purchase these securities with their own funds and thus the reserves of the banks decrease. Similarly, when the Fed increases the reserve requirement ratio, the banks have to keep more of their funds as reserves with the Fed. Thus, in this case the banks have lower amount of funds available to them for extending loans. In both these cases, when the excess reserves of the banks decrease, the interest rates will increase. Again, when the Fed increases the discount rate, other interest rates in the open market will also rise. Thus in all three cases interest rates will increase. This will discourage the economic agents to borrow loans from the banks. Thus, the agents will abstain from borrowing extra funds and their spending will also decrease from before. The householders will lower their purchase of commodities. Thus in equation (1), C will decrease. The investment in fixed assets by the householders, businesses and the government is also likely to fall. Thus in equation (1), ‘I’ also falls. The expenditure made by the State and the local government is curbed, so that in equation (1), G also decreases. As the domestic interest rates increase relative to the foreign rates, this will result in an increase of the foreign exchange value of the dollar. This in turn would make the U.S commodities more expensive in the foreign markets. Ultimately, this would cause the U.S exports to decline. In equation (1), X thus decreases (Saunders & Cornett 2007, pp. 114, 115). In equation (1), GDP = C + I + G + (X – M), following a contractionary monetary policy, C, I, G and X all decrease. This causes the GDP of the nation to decline. As the economic agents decrease their spending, real output and employment in the economy also declines. However, one advantage of this policy may be that inflation rates may fall in this case (Saunders & Cornett 2007, p 114, 115). Conclusion Therefore the Federal Reserve can use its three policy instruments: open market operations, the discount rate and the reserve requirement ratio to conduct monetary policy in the market. As a result, it can influence a number of variables in the economy. When the Federal Reserve wants to implement an expansionary monetary policy, it buys security in the open market or decreases the rate of interest or lowers the reserve requirement. This triggers a series of activities by which ultimately the GDP increases and the real output and employment of the economy rises. Conversely, when the Federal Reserve wants to conduct a contractionary monetary policy, it sells securities in the open market, or increases the discount rate or increases the reserve requirement ratio. This again starts a series of events by which finally the GDP contracts and the real output and employment in the economy also declines. Thus the Federal Reserve can exert its influence on the economy with the help of its policy instruments. References 1. Board of Governors of the Federal Reserve System (2011) Federal Open Market Committee retrieved on September 2, 2011 from http://www.federalreserve.gov/monetarypolicy/fomc.htm 2. Board of Governors of the Federal Reserve System (2011) Open Market Operations retrieved on September 2, 2011 from http://www.federalreserve.gov/monetarypolicy/openmarket.htm 3. Board of Governors of the Federal Reserve System (2011) The Discount Rate retrieved on September 2, 2011 from http://www.federalreserve.gov/monetarypolicy/discountrate.htm 4. Board of Governors of the Federal Reserve System (2011) Reserve Requirements retrieved on September 2, 2011 from http://www.federalreserve.gov/monetarypolicy/reservereq.htm 5. Board of Governors of the Federal Reserve System (2011) New Security Issues, State and Local Governments retrieved on September 2, 2011 from http://www.federalreserve.gov/econresdata/releases/govsecure/current.htm 6. Board of Governors of the Federal Reserve System (2011) Industrial Production and Capacity Utilization retrieved on September 3, 2011 from http://www.federalreserve.gov/releases/G17/Current/default.htm 7. Federal Reserve Statistical Release (2011) retrieved on September 3, 2011 from http://www.federalreserve.gov/releases/h3/current/h3.htm 8. InvestorWords.com (n.d) retrieved on September 2, 2011 from http://www.investorwords.com/2153/GDP.html 9. Saunders, A. & Cornett M.M (2007) Financial Markets and Institutions: An introduction to the Risk Management Approach India The McGraw Hill Companies Read More