The Effectiveness of the Federal Reserve in Stabilizing the Current Economy - Essay Example

The Federal Reserve Evaluate the role and the Effectiveness of the Federal Reserve in Stabilizing the Current Economy The FederalReserve is the most powerful institution in the American economic system. It is necessary to note that this institution is not an agency of the federal government, but it is a privately owned banking cartel, which has been given an exceptional monopoly over the U.S. monetary system by the United States Congress (Grey, 2002). The key objectives of the monetary policy are stipulated in the Federal Reserve Act. This act asserts that the Federal open Market Committee and the Board of Governors should always strive to promote the goal of stable prices, maximum employment, and moderate long-term interest rates (Grey, 2002). Stable prices in a long-term run are requirements for moderate long-term interest rates, maximum employment, and sustainable output growth. This is because, when prices are stable, the prices of services, goods, labor, and other materials are usually less affected by inflation. They also provide guidelines for the allocation of national resources and support services, thereby contributing to higher standards of living (Grey, 2002). Additionally, stable prices normally enhance capital formation and savings. This is because when the value of assets are being eroded due to inflation, there is always a need guard the assets against losses. This usually encourages businesses to invest more while households are encouraged to save more (Grey, 2002). The Federal Reserve Banks control the market for balances, which provides the initial link between the economy and the monetary policy. Depository institutions usually hold accounts at the Federal Reserve Banks, and they trade their balances at the federal funds market at a certain interest rate referred to as the federal funds rate (Grey, 2002). The Federal Reserve Banks have significant influence on the federal funds rate via its influence over demand and supply of the balances, at its premises. The Federal Reserve Banks normally set the federal funds rate at a level, which enhances monetary and financial conditions that are consistent with the monetary policy objectives. These banks also manipulate their targets that are consistent with the emerging economic developments (Grey, 2002). Therefore, a slight change in the federal funds rate and expectations about the future targets of federal funds rate can trigger a number of events, which will affect other long-term interest rates, short-term interest rates, stock prices, and foreign exchange of the dollar (Grey, 2002). Changes in these variables, in turn, affect businesses and households’ spending decision, thus affecting growth in the economy and aggregate demand. The present levels of the federal funds rates and the future expectation levels of the federal funds rate over a short-term run also affects short-term interest rates like those on commercial and Treasury bills papers (Grey, 2002). Therefore, short-term interest rates can decline if the Federal Reserve Banks convince market players that it will be setting the federal funds rate lower than they are expected or when the banks surprise market players with a reduction, in the federal funds rate (Grey, 2002). Likewise, the value of short-term interest rates will increase if the Reserve Banks announce that they will increase the federal funds rates, or if they convince the participants that they are going to hold federal funds rates at a higher level than they were expected. This is the reason why the depository institutions closely track statements and data released by the Federal Reserve officials to monitor prices and economy trends, which may shift in a direction that they were not expecting. Shifts in short-term interest rates influence long-term interest rates such as fixed-rate mortgages, corporate bonds, Treasury notes, and other consumer loans (Grey, 2002). On the other hand, long-term rates are affected by both shifts in the short-term rates and expectations about short-term rates over the lifetime of long-term contract. Economic statements and news by the Federal Reserve Bank officials have significant impacts on the short-term interest rates than on long-term interest rates because they directly define the direction of monetary policy and economy over a short-term run (Grey, 2002). However, the impacts of news and statements by officials also have considerable effects on the long-term rates because these statements have clear guidelines for the expected direction of the short-term rates over a long period. Furthermore, changes in long-term interest rates also have an impact on the stock prices, which in turn, have significant effects o household wealth. Companies and investors usually keep their investment returns on stocks in accordance to the return on bonds, after accepting higher risks on stocks (LaBonte & Makinen, 2006). For instance, when the long-term interest rates decrease, the returns on stock will overshadow return on bonds, and encourage participants to buy stocks and set stock prices at levels that are in line with returns on stocks and bonds. In addition, lower interest rates can lure investors that the profits will be higher and the economy will be stronger, in the future (LaBonte & Makinen, 2006). Determine Economic Indicators the Federal Reserve Should Analyze so it can Better Stabilize this Particular Economy The Federal Reserve Committee and the Federal Reserve System’s Federal Open Market Committee (FOMC) hold regular joint meetings after every six weeks to address concerns pertaining Federal monetary goals and actions, and the federal funds rate targets. FOMA is Federal Reserve System’s policy-making body, which assesses economic indicators before determining monetary policy (Grey, 2002). The key economic indicators that FOMC adapts to economy include inflation rate, employment and unemployment rate, real Gross Domestic Product, and Federal Reserve. The United States Bureau of Labor Statistics provides a report on the rate of inflation and estimated level of price index (CPI) in the U.S. for the previous month (Grey, 2002). This report is released every month, and it provides significant information about the seasonally and currently adjusted consumer price indexes for all urban wage earners, and urban consumers. Inflation reduces the level of investment and the efficiency in the use of productive factors. It also has a considerable impact on the long-term growth rates, which also trigger a permanent decrease of the income per capita (Grey, 2002). The rate of the U.S. unemployment has increased over the past decades, and economic experts have predicted that, though the U.S. economy has recovered from the recent recession, unemployment rate will remain high in the coming years. In 2012, the unemployment rate decreased to 7.8 percent from the previous year. Employment rate increased in the transportation and warehousing, and health care but sectors, but little change was witnesses in the other major industries (Axilrod, 2011). Real GDP establishes the level of economy viability, and the economic sectors that are more productive. GDP is also used to compare the magnitude of economies throughout the world. The Federal Reserve manipulates both long-term and short-term federal funds rates. For instance, the Reserve has reduced its forecast for economic growth from 2.9 percent to 2.4 percent, in 2012 (Axilrod, 2011). Describe which Monetary Policies the Federal Reserve might use to influence the Money Supply The Federal Reserve Bank utilizes three monetary policy tools to influence the cost and availability of credit and money. These tools include open market operation, reserve requirements, and the discount rate (Axilrod, 2011). The most commonly used tool is open market operations for selling and buying government securities. FOMC sets Fed’s monetary policy that is performed through the trading desk of the Federal Reserve Bank of New York. For instance, when the FOMC decides that more credit and money should be made available, it directs the New York desk to buy securities from the open market (Axilrod, 2011). The securities are paid by crediting reserve bank accounts, and with more money in these accounts, banks have more money to lend, which may decrease interest rates that will, in turn, cause businesses and consumer to increase their spending, thus encouraging economic expansion (Axilrod, 2011). The discount rate refers to the interest rate that the Federal Reserve Bank charges depository institutions when they borrow funds on a short-term contract. The bank’s officials set these rates and they have direct influence on other open market interest rates, in the economy (Axilrod, 2011). A higher discount rate represents a more restrictive policy while a lower rate indicates a more expansive policy (Axilrod, 2011). Under the U.S. Constitution, all financial institutions are members of the Federal Reserve System. Therefore, they must set part of their funds, in the reserve bank’s accounts. The Reserve Bank also sets the requirements for all savings unions, commercial banks, and savings and loan. Depository institutions use their reserve bank accounts to process many financial transactions such as currency and coin services, and check and electronic payments (Axilrod, 2011). The Federal Reserve Bank supports the implementation of monetary policy, which increases the institution’s influence over short-term interest rates (Axilrod, 2011). Explain the Strengths and Weaknesses of Using Monetary Policy in Comparison to Fiscal Policy When Promoting Economic Activity and Preserving Price Stability Monetary policy and fiscal policy are tools used to increase or decrease aggregate demand, and increase aggregate supply (LaBonte & Makinen, 2006). Monetary policy is influenced and managed by the Federal Reserve Board, and it is meant to increase or decrease the money supply through changes in the discount rate, open-market operations, and changes in reserve requirements (LaBonte & Makinen, 2006). On the other hand, the Congress and President manage fiscal policy, and it deals with the changes in the government spending and taxes (LaBonte & Makinen, 2006). Shifts in the monetary policy influences inflation, economic growth, consumption, and changes in the interest rates that affects supply and investment. One of the key strength of monetary policy is stabilizing prices. Inflation reduces the value of money, by reducing it purchasing power (LaBonte & Makinen, 2006). When inflation increases at a faster rate that was not expected, the Federal Reserve Bank responds by selling government bonds to raise short-term interest rates or take money out of circulation. This slows down consumer spending, and reduces access to credit, thus countering inflation. However, the monetary policy has conflicting goals. The objective of low inflation and sustainable economic growth often conflict (LaBonte & Makinen, 2006). A growing economy with lower unemployment rate may cause inflation to increase. This is the reason why monetary policy usually slows economic growth to reduce inflation. Analyze the Effect of the Federal Reserve’s Action on the Aggregate Demand/Supply Model The aggregate demand/supply model is used to analyze the behavior of macroeconomy in short-run, medium run, and long-run (Grey, 2002). Aggregate demand is the total spending by businesses, households, foreigners, and businesses on domestically produced services and products. The Federal Reserve Bank manages monetary policy, which increases or decreases the money supply through changes in the discount rate, open-market operations, and changes in reserve requirements. This means that the relationship between the amount of services and goods people are willing to buy and the inflation rate is inverse, when some other things remain constant. This is because when prices raise faster (inflation), the purchasing ability of people’s wealth decreases at a faster rate than before, and this reduces the purchase of goods and services (Grey, 2002). News or statements released by the Fed usually cause shifts in the aggregate demand curve. On the other hand, aggregate supply curve illustrates the behavior of producers of final services and goods in aggregate (LaBonte & Makinen, 2006). News released by Federal Reserve Bank officials changes input prices. For example, a company’s average profit varies in the same direction as the rate of inflation (LaBonte & Makinen, 2006). Therefore, rapid increase in profit margins encourages companies to increase their productions. References Axilrod S. H. (2011). Inside the Fed: Monetary Policy and Its Management, Martin Through Greenspan to Bernanke. New York: MIT Press. Grey G. B. (2002). Federal Reserve System: Background, Analyses and Bibliography. New York: Nova Publishers. LaBonte M, Makinen G. E. (2006). Monetary Policy And Price Stability. New York: Nova Publishers. Read More