Monetary policy in the US - Research Paper Example

? [DAY November EXECUTIVE SUMMARY This paper offers an in-depth analysis of the monetary policy of the United States of America. The report achieves it by interconnecting the country’s monetary policy and both its past and present economy. It involves monetary theory and other economic concepts in demonstrating how the country’s limitations and capabilities affect the country’s economic development and the quality of life of its people. The country’s monetary policies and natural resources set the country’s limitations and capabilities. Furthermore, it investigates the factors affecting the complexity of the formation of the U.S. monetary policy. It includes the country’s Gross Domestic Product, foreign exchange reserves, investment inflows and outflows, tax regime, and the structure of its Central Bank. In addition, it includes the major players in its economy and others factors deemed helpful for the accomplishment of the report. Finally, the report analyses and concludes on how these factors affect the monetary policy of United States. TABLE OF CONTENTS PAGE EXECUTIVE SUMMARY 1 TABLE OF CONTENTS 2 1. INTRODUCTION 3 2. LITERATURE REVIEW 3 3. THE RESEARCH 4 3.1 BACKGROUND OF THE U.S. ECONOMY 4 3.2 CENTRAL BANK OF THE UNITED STATES 5 3.3 BANKING SECTOR 7 3.4 INTEREST RATE AND MAJOR ECONOMIC SECTORS 9 3.5 KEY ECONOMIC AND MONETARY INDICATORS 11 3.6 OTHER ECONOMIC FACTORS 12 4. DATA ANALYSIS AND KEY LEARNINGS 13 5. CONCLUSION AND RECOMMENDATION 14 1. INTRODUCTION For many years, the people who study Economics, especially in the field of macro-economics, have given an utmost importance on the study of monetary policy. It is very crucial in understanding the economic system of one country. Many people consider the country’s monetary policy as a complex economic subject. A monetary policy is the number one responsible for the country’s economic progress and the state’s overall development. The country’s monetary policy manages extensively all financial matters that concern the state. Its formulation requires a wide-range of consideration and employs complex economic concepts. Various factors affect the country’s financial condition which in effect impacts the overall development of the monetary system. It is the same with the United States, it takes a careful study and analytical approach when dealing with the monetary policy of the country. 2. LITERATURE REVIEW There had been numerous texts on the subject of monetary policy published in the past. It ranges from the theory of monetary policy to specific monetary policy applications. Authors like Michael Woodford, V. Chick have written manuscripts on the Theory of Monetary Policy such as the Interest and Prices: Foundations of a Theory of Monetary Policy, and The evolution of the banking system and the theory of monetary policy, respectively. Frederic Mishkin has written a Monetary Policy analysis in Monetary Policy Strategy. Manuscripts about monetary policy in the U.S. had also been published by authors like Richard Timberlake and John Odell. Monetary Policy in the United States: An Intellectual and Institutional History, and U.S. international monetary policy: Markets, power, and ideas as sources of change, respectively. 3. THE RESEARCH 3.1 BACKGROUND OF THE U.S. ECONOMY Today, America is one of the richest countries in the world with a Gross Domestic Product (GDP) per Capita of $48,442 (“World Bank”). It ranked seventh on Forbes 2012 World’s Richest Countries based on the Purchasing Power Parity Adjusted - GDP per Capita (“World’s Richest Countries”). In terms of the Gross Domestic Product (GDP) alone, America has the largest national economy in the world. The country currently has a GDP of $14, 657.8 billion which corresponds to almost 25% of the entire world’s GDP (“2012 Macro-Economic”). The country dominates world’s major industries like electronics, energy and medicine in the form of services, industrial and trading (“U.S. Manufacturing”). In effect, the country has high employment rate, high productivity and large national income. America also possesses massive natural resources such as oil and natural gas as they are one of the largest producers of these energies. The United States continues to dominate the major industries in the world and its economy grows even more. For the past decades, America’s GDP growth rate averages an annual rate of 3.5% (“United States GDP”). Currently, even though the U.S. is still recovering from a financial recession, its economy is still on the rise with a 2% annual GDP growth rate (“United States GDP”). 3.2 CENTRAL BANK OF THE UNITED STATES PROFILE OF FEDERAL RESERVE For almost every country there is a central bank which manages all monetary concerns of the country. Generally, the main function of the central bank is to oversee the monetary policy of the country to protect and develop its financial condition. Central Banks may have various designations in other countries but they basically perform the same function. In the United States, the Federal Reserve System or simply Federal Reserve acts as the central bank of the country. It was created in 1913 as a result of the Federal Reserve Act that is to provide the country with safer and more stable monetary system (“Federal Reserve System”). At present, the three main responsibilities of the Federal Reserve in the U.S. involve in the monetary policy, payments services, and the supervision and regulation of financial institutions (“U.S. Central Bank”). The Federal Reserve System consists of a Board of Governors with seven members. The President of the United States appoints these members and the Senate later on confirms the appointment. Furthermore, the President selects two of the board members as Chairman and Vice Chairman, respectively. The Senate again authorizes the appointment of both the Chairman and the Vice Chairman. The main responsibility of the Board of Governors is to formulate the monetary policy of the country (“Structure of the Federal Reserve”). To accomplish other functions of the Federal Reserve, the board members join five Reserve Bank presidents to form the 12-member Federal Open Market Committee (FOMC). Boards of Directors from 12 Reserve Banks select the five bank presidents in the FOMC. Their main functions are the ones that affect the cost and availability of money and credit in the economy. It sets the margin requirements to limit the use of credit for purchasing or carrying securities (“Structure of the Federal Reserve”). Also, the committee acts as the regulatory and supervisory body of the banks in the country and other bank-related activities. The committee also regulates and administrates the implementation of government laws that concern the financial stability of the country. Examples of these laws are Equal Credit Opportunity Act and Truth in Lending Act (“Structure of the Federal Reserve”). The president selects members of the Board of Governors in consideration with the interest of the nation and various groups in the country. Also, the appointed Chairman of the Board of Governors usually assumes the Chairmanship position in FOMC. Likewise, the Federal Open Market Committee does its job under the same principles. To do this, the Federal Reserve people regularly meet with the Congress for the interest of the nation, academicians, bank representatives and other groups inside and outside the country (“Structure of the Federal Reserve”). RECENT MONETARY POLICY One of the most recent steps that the Federal Reserve took was the approval of the 2011 Banking and Consumer Regulatory Policy. It aims to protect the consumer’s investment in the event that the bank experiences a financial distress. It requires bank holding companies with $50 or more and nonbank financial firms under supervision to annually submit a resolution plan to the Federal Reserve (“Banking and Consumer Regulation”). The plan includes the strategic approach in the event of bankruptcy and also discusses the organizational structure of the company, its interdependencies and other components that relates to the company’s financial stability (“Banking and Consumer Regulation”). The Federal Reserve also committed to provide more transparency by submitting unaudited financial reports more frequently starting 2012. The Federal Reserve is now to submit financial reports, as a result of its operation, four times a year from the previous annual submission (“Chronology: Federal Reserve's transparency steps.”). On earlier years, the Federal Reserve has already taken key steps to improve their operations. The Federal Reserve increased the frequency and horizon of its forecast in 2007. Two years later, the committee also expanded its projections for GDP, unemployment and inflation (“Chronology: Federal Reserve's transparency steps.”). 3.3 BANKING SECTOR BANKING INSTITUTIONS The banking sector is one of the most affected industries by the financial crisis in the United States as a result of the current global recession. It becomes evident through the significant decrease in the number of commercial banks and savings institutions in the country. At the start of the year 2012, there was an expected 4.4% decline in the number of banking institutions in the United States (“Shrinking U.S. Banking Sector”). The number of banks leaving the sector is higher than the banking institutions entering. In 2010, there were 157 bank failures in the country while only 11 banks that entered the sector (“Shrinking U.S. Banking Sector”). On the other hand, the banking sector in the U.S. is still internationally competitive relative to other developed countries such as those in Europe. One of its indicators is the relatively low Loan-to-Deposit ratio of U.S. banks as compared with European banks. On Figure 3.1, it shows a graphical representation of the Loan-to-Deposit ratio comparison between U.S. banks, European banks and Japan banks. The following graph shows that the U.S. banks have much lower Loan-to-Deposit ratio than European banks and expected to be lower than Japan Banks in the following years. Figure 3.1 Loan-to-Deposit Ratio in Banking Sectors (“U.S. Banking Sector”). MAJOR PLAYERS For many years, J.P. Morgan Chase & Co. and Bank of America Co. interchangeably occupy first and second places in the list of the largest banks in the United States. Both companies become even larger in its assets each year. Although the Bank of America Co. holds the number one position as the largest bank for most of the recent years, J.P. Morgan Chase & Co. leads the banking sector in 2012 with a $2.3 trillion in assets and $1.1 trillion in deposits (“America's Biggest Banks”). The Bank of America Co. ranks second with a $2.2 trillion in assets and $1 trillion in deposits. Citigroup, Wells Fargo & Company, and Goldman Sachs Group hold the last three positions in the top five, respectively (“America's Biggest Banks”). Table 3.1shows the assets of the ten largest banks in the United States from year 2009 to 2012. Rank Company 30/06/2012 Assets, $m 31/12/2011 Assets, $m 31/12/2010 Assets, $m 31/12/2009 Assets, $m 1 J.P.Morgan Chase & Co 2,290,146.0 2,265,792.0 2,117,605.0 2,031,989.0 2 Bank of America Corp 2,162,083.4 2,129,046.0 2,264,909.0 2,230,232.0 3 Citigroup 1,916,451.0 1,873,878.0 1,913,902.0 1,856,646.0 4 Wells Fargo & Company 1,336,204.0 1,313,867.0 1,258,128.0 1,243,646.0 5 Goldman Sachs Group 948,981.00 923,225.00 911,332.00 848,942.00 6 Morgan Stanley 748,517.00 749,898.00 807,698.00 771,462.00 7 U.S. Bancorp 353,136.00 340,122.00 307,786.00 281,176.00 8 Bank of New York Mellon 330,490.00 325,266.00 247,259.00 212,224.00 9 HSBC North America Holdings 317,482.38 331,402.98 343,699.91 391,332.07 10 PNC Financial Services Group 299,712.02 271,205.00 264,284.00 269,863.00 Table 3.1 Largest Banks in the United States (“The Largest US Banks”). 3.4 INTEREST RATE AND MAJOR ECONOMIC SECTORS INTEREST RATE MOVEMENT Another function of the Federal Reserve is to determine the appropriate interest rate in the country. The Federal Reserve sets the country’s interest rate based on the market which is referred as the base interest. When the country’s interest rate or simply Federal Reserve Rate is not the same with the base rate, it increases the interest rate on various products such as mortgage, loans, and savings (“FED Federal Funds Rate”). Federal Reserve Rate is the daily interest rate which one bank charges the other for lending (“FED Federal Funds Rate”). The country always tries to keep its interest rate at a low level to ensure factors like high employment rate, price stability, and financial system stability as these are indirectly affected by the country’s interest rate. On Figure 3.2, the graph illustrates the United States’ interest rate movement in the last 20 years. For the last three years, the Federal Reserve was able to maintain the U.S. interest rate at a record low of 0.25% (“FED Federal Funds Rate”). The Federal Reserve sets it target range at 0% to 0.25% in the succeeding years (“U.S. Keeps Monetary Policy Unchanged.”). Figure 3.2 U.S. Interest Rate trend (“FED Federal Funds Rate”). KEY INDUSTRIES The United States has the largest national economy in the world largely because of the key industries and major economic sectors in the country. These industries make up the country’s overall Gross Domestic Product (GDP) of about $14, 657.8 billion in 2012 together with other minor economic sectors (“2012 Macro-Economic”). The economy of the United States consists of a wide-range of industries from Agriculture to Service. The U.S. economy consists of three major sectors such as Service sector, Industrial sector, and the production and manufacturing sector. Out of the three, the service sector is the largest economic sector in the United States contributing 78.5% of its overall GDP in 2007 (“Different Sectors”). Major industries in the service sector are Information, retail, scientific, technical and professional services. The next largest sector is the industrial sector in the form of electronics, petroleum, chemicals, fertilizers, electronic goods among others. In 2007, the industrial sector contributed 20.5% of the country’s overall GDP (“Different Sectors”). Lastly, the production and manufacturing sector contributed the GDP’s 0.3% in the same year. Today, the performance of the economic sectors in the country becomes even stronger but shows no significant changes in the position relative to each other. 3.5 KEY ECONOMIC AND MONETARY INDICATORS The performance of the key industries and major economic sectors also proves to be vital as an indicator of the country’s economy. The Federal Reserve uses these economic indicators as important component in its decision-making and operation. Some of the key economic indicators in the country are Employment Trends Index, Consumer Expectations, Measure of CEO confidence, and Leading Credit Index. The Federal Reserve uses monetary indicators such as stock market prices, Treasury bill rates, and credit market conditions to help them in forming the country’s monetary policy (“monetary indicators”). The graph on figure 3.3 shows the trend of 2012 key economic indicators in the country. Figure 3.3 2012 Key Economic Indicators (“Leading Economic Indicators”). 3.6 OTHER ECONOMIC FACTORS TAX REGIME In the tax regime of the United States, its corporate tax policy is the most alarming on its economy. The U.S. has the largest corporate tax rate in the world at 35% (“U.S. Corporate Tax Reform”). It also taxes the foreign profits of U.S. multinational corporations which may be used by other industrialized countries, which only tax domestic corporate income, as an advantage to attract more foreign investors (“U.S. Corporate Tax Reform”). It also encourages business investors to form non-corporate entities instead which are not taxed which in effect bring corporate businesses many disadvantages (“U.S. Corporate Tax Reform”). INVESTMENT FLOWS AND SECTORS The United States acquires a large portion of its investment inflow mainly from foreign investors. In 2008, the U.S. Department of Commerce an all-time high of foreign investments of $328 billion was recorded (“United States”). Table 3.2 shows the top foreign investors in the United States in 2010. Their total investments amounted to 84% of total inflow of the United States in industries like petroleum, electronics, and production. Country Switzerland United Kingdom Japan France Germany Luxembourg Netherlands Canada Investment (Billion) $37 $33 $22 $21 $20 $12 $12 $9 Table 3.2 Top Foreign Investors (“United States”). 4. DATA ANALYSIS AND KEY LEARNINGS While the measurement of the country’s financial condition is its Gross Domestic Product (GDP), it is the monetary policy that determines the direction of the economic state of one country. For instance, the United States has the largest GDP which makes its economy the largest in the world, but certain monetary policies affect its employment rate, interest rate, amount of foreign investment and other factors that could result to an economic recession. Specifically, its corporate tax policy affected the businesses in the country which reduced the number of corporate businesses in the country. It also affected foreign investors as they consider of investing to other industrialized countries which have lower corporate taxes. Key monetary and economic indicators also affect the policy-making of the Federal Reserve which again impacts the everyday life of Americans. In the case when the country’s interest rate is high, the citizens pay more on mortgages, loans, and savings. Definitely, the present monetary system of the United States has many flaws and has plenty room for improvement. The Federal Reserve has already offered several reforms towards the improvement of its monetary system but still careful planning and studies have to be executed. 5. CONCLUSION AND RECOMMENDATION As a summary, the research results prove that monetary policy is indeed a complex economic concept as related both to macro-economics and micro-economics. Moreover, it shapes the country’s economic growth and overall development. As in the case of the United States, the monetary policy, as administered by the Federal Reserve, largely impacts its success as a country. As a recommendation, studies on the monetary policy of other specific countries can be of significant help to this manuscript and to other studies on monetary policy. 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