Federal reserve monetary policy - Term Paper Example

Money is a medium through which exchange takes place. Encyclopedia of Britannica defines function of money as a facilitator of the transaction between buyer and seller; however, money can be defined mainly in terms of three functions; as a medium of exchange, as a unit of account and as a store of value. (Functions of Money) If money had not been there all transactions would have to be done through barter system. That is a tedious process on day to day operations. Money also functions as a unit of account measuring the value of goods or services under exchange.

Money holds some value at given time so it is a storehouse of value. It is not a best storehouse as it tends to depreciate overtime, if seen in the context of other assets such as land, gold, and silver. It is most liquid of all assets and its store value helps make us transaction. (Functions of Money) Central Bank Manages a Nation’s Monetary System The broad economic goals of monetary policy are full employment, sustainable economic growth, and minimum inflation. The Federal Reserve achieves these goals by regulating and controlling the growth of money and availability of credit.

It achieves its goals either by open market operations, altering lending rate or reserve ratio. (The Fed Today) A) Open Market Operations The Fed's tool for mitigating the effect of inflation and recession is through open market operations. The central bank sells and buys U.S. government securities in the open market; thus, influencing short-term interest rates and the growth of credit and money. When not enough money is available in the financial system causing economic slowdown called recession, the central bank buys securities.

The funds used by the Fed in purchasing the securities will eventually arrive at local banks, which then will have more money to lend. This way more money will come into the financial system and create stabilizing effects. On the contrary, when the Fed realizes market is hot and too much money is in circulation or credit are available in the market causing inflation, the Fed will interfere and sell securities of banks. Thus extra money will be squeezed out of the system, reducing inflationary pressures and stabilizing the economy.

(The Fed Today) Thus, final goal of monetary policy is a stable economy providing full employment and production, stable prices and steady growth. B) The Discount Rate The Discount rate is the intervening tool at the disposal with the Fed. It is the interest rate financial institutions charged by the Fed for short-term loans. Altering discount rate can discourage and encourage bank's investment and lending activities signaling central bank's goals and influencing the interest rates that banks offer loans at and pay to depositors.

(The Fed Today) C) The Reserve Requirement The fed makes it mandatory to keep certain percentage of checking account deposits as reserve. Simply raising the reserve requirement banks will have less money to lend thus, restricting the money supply. Opposite is also true; reducing the reserve ratio, banks will have more free money to lend and thus, money supply will increase. This tool is rarely used. Reserve requirement changes are indication that monetary policy is now moving toward a new direction.

(The Fed Today) Stated Direction of Monetary Policy Since the 2001 recession and with the rising unemployment rate until mid-2003, the Fed reached to low interest rates of 1% by mid-2003. With the expansion and rising prices, the fed revised its target upward to reach 5.25% by mid-2006. With the economy entering into recession by December 2007, the target interest rates moved downward to 0 and 0.25 percent during December 2008. (Labonte, 2010) What came into notice of the monetary authorities that liquidity was not reaching to the financial system.

Traditional transmission mechanism of monetary policy was not functioning. On this, the fed started making loans to non-financial firm and other financial institu