Monetary policy: the Federal Reserve Bank of the U.S.A - Essay Example

Article Analysis Contents Introduction 3 Article Analysis 3 Conventional Monetary Policy 3 Policy during Recession 5 Commenting on the macroeconomic principles 7 Works Cited 8 Name of the Student Name of the Professor Course Number Date Article Analysis Introduction Monetary policy is an integral part of macroeconomics that creates ripples in the entire economic system of a country. It has the power to influence the price level of the economy and the overall economic growth. Monetary policy is a tool employed by the central banks of countries to produce favourable changes in the aggregate demand to boost an economy out of its sluggish phase (Carbaugh 355). Conventional economic wisdom states that central banks of countries mainly regulates the monetary policy by purchasing or selling government securities in the open market, slashing or enhancing the discount rate and increasing or reducing the reserve requirements (Mankiw 69). The purpose of this paper is to focus on the monetary policy of the Federal Reserve Bank of the U.S.A. particularly during and after the global financial crisis. This paper summarizes the article “Monetary Policy and the Federal Reserve: Current Policy and Conditions” published by the government think tank of the Congress. The article is authored by Marc Labonte. The article comprehensively discusses the main policies that had been taken by the Federal government during the sluggish phase of 2008-2013 to restore equilibrium in the recessionary economy. Article Analysis Conventional Monetary Policy The conventional monetary policy of the Federal Reserve was mainly based on targeting the federal funds rate. Labonte (2014) reports that the government had initially operated through setting an interest rate target that could meet the goals of stable prices, maximum employment and long-term growth. In other words this type of a monetary policy has also been termed as management of aggregate demand so as to eliminate fluctuations in the business cycle. The Federal Reserve had primarily operated through the open market mechanism historically in which the inter-bank lending rates were scrutinized (Labonte, “Monetary Policy and the Federal Reserve: Current Policy and Conditions”). In such a type of monetary policy the interest rates are raised soon before the economy reaches the level of full employment. This helps in restoring equilibrium and ensures that the growth is sustainable. This vision is combined with the basic idea of creating a favourable level of employment in the country (Labonte, “Monetary Policy and the Federal Reserve: Current Policy and Conditions”). In Open Market Operation (OMO), the central bank buys securities issued by the U.S. treasury. In case of purchasing the new securities the bank has to issue new currency to expand the reserve base. This is done in order to expand the monetary base of the economy so that the financial institutions can provide loans to the business enterprises and raise credit. The second conventional policy as pointed out in the article is the reserve requirements ratio. This is a measure by which the central bank controls the overall level of deposits that commercial banks maintain with it. This is a key technique in which the liquid cash is maintained within the economy. This policy is however not exercised actively by the bank and the rates had not been revised in the past ten fifteen years. In the current economic scenario, banks are required to maintain an overall of 0% to 10% (Labonte, “Monetary Policy and the Federal Reserve: Current Policy and Conditions”). The exact value is determined by the size of the banks. Ever since 2008 the government has decided to pay interests on the excess reserves. Finally, discount policy is another such mechanism in which the central bank promotes internal lending and borrowing among banks. This is a temporary arrangement for borrowing money by financial institutions Commercial financial institutions can discount their own assets to the central bank and raise assets (Labonte, “Monetary Policy and the Federal Reserve: Current Policy and Conditions”). The Federal Reserve can also charge a fee in return of provision of this service and this fee is called the discount rate. Labonte had pointed out that the discount rate in the U.S.A. has been historically set above the discount rate. The use of discount window in lending of funds is not normally exercised. Federal funds rate can be described as an interest rate that exists in the private assets market. For instance, some organizations may have excess reserve and others may have shortages. In such situations the private financial institutions having shortages can borrow and lend money on an overnight basis. Lowering the federal funds rate provides a major motivation for funds to borrow money from one another and this stimulates the domestic demand. In order to support the lower interest rates it becomes mandatory to purchase government securities. The government of the U.S.A. had mainly focused to control the federal rates ever since the crisis of 2001 as it had anticipated that the level of unemployment had increased. Since 2003 the targeting of federal funds became the topmost priority and the value was raised to 5% and it remained at this level till 2007 (Labonte, “Monetary Policy and the Federal Reserve: Current Policy and Conditions”). Policy during Recession The work of Labonte (2014) had provided specific details of the work that had been taken up by the government to pull the economy out of the recession. The author states that conventionally the Federal government had focused on devising policies based on the open market mechanisms. However, ever since the recession had hit the economy of the U.S.A. the government had focused devising alternative strategies to boost the economy. Federal funds rate was the prime focus of boosting economic activity. Over the past six years the government had remodelled the federal funds rate ten different times from 5.25% to 0.25% (Labonte, “Monetary Policy and the Federal Reserve: Current Policy and Conditions”). This policy was also combined with open market mechanisms when the government had decided to initiate unsterilized purchase of government securities. Labonte describes that overall the government had taken three measures to encourage the economy and boost its demand. The first one is the targeting of the federal rate; the second one is the concept of forward guidance and finally open market mechanisms performed through purchase of assets. Forward guidance is a relatively new concept in which the bank has promised to keep its interest rates low even if the unemployment level reaches its natural value. All of these policies had a common agenda which was to increase the investor confidence in the economy and influence the private interest rates. Reducing the interest rates automatically increases the spending of business enterprises to boost their physical capital. Additionally, it also enhances the propensity of the people to spend higher amount on the purchase of goods and services and the aggregate demand of the economy increases. As the recession had particularly depressed the spending of both people and business so the Federal Bank was keen on enhancing the domestic demand (Labonte, “Monetary Policy and the Federal Reserve: Current Policy and Conditions”). Labonte prudently points out that this type of a monetary policy which focuses on very low interest rates to enhance commercial borrowing has its own share of risk and benefits. The benefits are mainly short-run and are focused on boosting on the demand. However, one of the major disadvantages of this approach is that this type of a monetary policy can foster inflation in the long-run which can bring significant disadvantages to the economy. On one hand, withdrawing this type of a monetary policy is going to jeopardize the long-term employment target of the government and following this policy too long in the future will cause inflation rates to skyrocket (Labonte, “Monetary Policy and the Federal Reserve: Current Policy and Conditions”). The article points out that at such a juncture it was impossible for the Central Bank and the government to take up policies which could boost domestic demand. The article has also pointed the failure of the conventional monetary policy to improve the economic conditions. This was the time when the monetary policy had to remodelled and existing conventions had to be broken. Among the three conventional policies that are otherwise used by the government became useless in the face of the crisis. The only convenient policy for the government was to resort to measures it had not taken in the past. The article of Labonte specifically mentions that the OMO used by the government simply became ineffective to provide additional stimulus to the economy in the short-run. The second common policy of reserve requirements was again not a potential instrument as the government had hardly modified this rate. Additionally, the commercial banks hardly had money left to hold it as a reserve with the central bank. According to the author the final option that was left to the Federal Reserve was to consider the option of discount window (Labonte, “Monetary Policy and the Federal Reserve: Current Policy and Conditions”). The author has documented it was the discount window mechanism that was primarily targeted by the central bank to regulate money supply. The discount window has been widely availed by most of the financial institutions during the crisis because it became quintessential for the commercial banks to borrow money for a short-period. Under such circumstances discount borrowing became the lone source of funding for the banks and they did it extensively to fund their ongoing operations. However, it was soon realized that following the discount rate was not a sufficient measure to control the impact of recession. It was for this reason that the central bank had decided to supplement the conventional monetary policy with other measures like forward guidance and quantitative easing (Labonte, “Monetary Policy and the Federal Reserve: Current Policy and Conditions”). This value was five times higher the pre-crisis level. The monthly purchase of the mortgage-backed securities had been considered as a bold step by the government to recover the economy. However, Labonte had wisely pointed out that the zero lower bound policy followed by the government would make the traditional monetary possible useless. Commenting on the macroeconomic principles The gist of the article raises a rather odd question on the effectiveness of conventional monetary policy. As per conventional macroeconomic theory of money supply, three possible avenues of monetary policy have been used by central banks all over the world to control liquidity policy of the government. Economists had also pointed out that following an expansionary monetary policy may create problems of hyperinflation for the nation as a whole and it becomes crucial to control the trajectory of expansion (Carbaugh 355). However, the main theme of the chosen article was the way the government of the U.S.A. have followed an expansionary monetary policy in face of the recession. The most striking difference of the chosen article from the economic reality is its deviation from the use of conventional monetary instruments. In times of financial prosperity it has been found that Federal Bank of the United States has been mainly operating through open market mechanisms. This policy has been well documented by macroeconomists. The recession of 2008 had however witnessed a paradigm altering action on the part of the Central Bank. Conventional monetary policy had failed and the bank had no other options but to incorporate certain special features like forward advances and quantitative easing. This was coupled by keeping the interest rates to the lowest possible level. These policies had not been pointed out in the conventional literature of the monetary policy and can be considered as an entirely new approach that will be explored further in the future. Though this policy may have corrected the short-run situation of the country but there is no denying the fact that such a policy can have adverse impacts on the inflation front. The article has expressed this fear in the research. It has also pointed out the fact that if the bank is unable to control the inflation then the consequences will be grave. The present issue facing the central bank of the U.S.A. is the time till which it should continue its expansionary policy. Therefore, even if the Federal Reserve have followed an unconventional monetary policy, the conventional economic wisdom which states that expansionary monetary policy can lead to hyperinflation holds true. If the central bank is unable to control this issue then further problems are likely to arise. Works Cited Carbaugh, Robert J. Contemporary economics: an applications approach. New York: ME Sharpe, 2013. Print. Labonte, Marc. “Monetary Policy and the Federal Reserve: Current Policy and Conditions.” Congressional Research Service, 2014. PDF File. Mankiw, N. Gregory. Principles of macroeconomics. Connecticut: Cengage Learning, 2014. Print. Read More