What is the Federal Open Market Committee - Assignment Example

MACRO What are sthe chances of winning the "Pick 3 Exact Order" Game at the Virginia Lottery Web site. How much can you win? What is the expected return? Is paying $1 to play this game rational? By betting $1 on “Pick 3 Exact Order,” on the appearance of the numbers 1, 2 and 3 in exact sequence, the payoff is $500, but the true odds is $1000:1, based on the the equation: (l/10)(1/10)(1/10) = l/1000. When compared with state lotteries where the chance of winning is 1 in l million, or 1 in 14 million, this makes more sense. However, compared to casino table games, this is an inferior game to play if one considers the odds alone. The payoff in roulette, in contrast, is 1:1 when the odds are 1:1.06; in baccarat it is even better, with 1:1.017 on Bank and 1:1.0136 on Player. In other words, the house edge in the casinos is very small when it pays you $1 for a $1 bet. In this Virginia lottery game, one is paid $1 when the true odds are 1:2 - in short, the house edge is extremely high, about twice the level of the true odds. The issue is: Is it rational to bet in this game? Some would argue that it is not rational to bet at all. Let us attempt to define the terms rational and rationality. Rational is defined by the dictionary.reference.com as "agreeable to reason; reasonable; sensible. Its synonyms are: intelligent, wise, judicious, sagacious, enlightened and its antonyms stupid, insane. The Philosophy Dictionary defines rationality (http://www.answers.com/topic/rationality) as pieces of behavior, beliefs, arguments, policies, and other exercises of the human mind may all be described . . . as making sense, as appropriate, or required, or in accordance with some acknowledged goal, such as aiming at truth or aiming at the good. In economics, we likewise encounter the term rational or economic man (homos economicus) as a person who acts to obtain the highest possible well-being for himself given available information about opportunities and other constraints, both natural and institutional, on his ability to achieve his predetermined goals. He is "rational" in the sense that his wellbeing, as defined by his utility function, is optimized given perceived opportunities, that is to say, he achieves his goal at minimal cost (See answers.com). Given an uncertain outcome, the rational man would try to maximize his expected value, which is defined by the Accounting Dictionary (2005) as the weighted average using the probabilities as weights. The concept of expected value provides a rational means for selecting the best course of action. The expected value (E(x)) is found by multiplying the probability of each outcome by its payoff. E(x) = Sxi pi where xi is the outcome for ith possible event and pi is the probability of occurrence of that outcome. Betting $1 on a toss of a coin, ones expected value should be: $1(.5)=0.50 cents; and for the Pick 3 Exact Order, $1(.00l) or one-tenth of a cent – but they payout would make it one-twentieth of a cent. One does not expect much but hopes that luck would someday be kind and give one a win. On a practical level, an important variable for the bettor is his indifference curve, a term used in microeconomics, as between holding the $1 for future consumption or for saving against betting it on the lottery. Because the amount is insignificant in relation to his total income, he would probably be willing to part with it in exchange for the slight chance of winning the lottery and/or in the expectation that the proceeds from the lottery would be used for some good or charitable cause. Then his utility would mainly be his good feeling of having contributed something of value to society. In this sense, then, from the viewpoint of that particular individual, his betting in the lottery can be considered rational. However, when the level of his bet increases to, say, 50 per cent of his income, the premises have changed considerably, his bet will likely be considered, irrational, stupid, or even insane. 2. What is the Federal Open Market Committee (FOMC)? What are the tools the FOMC uses to meet its objective(s), and how does the committee utilize these tools? What is the membership composition of the FOMC, and who are the current members? The U.S. Federal Reserve was given the responsibility by the Federal Reserve Act of 1913 for setting monetary policy, and, to discharge this task, it controls the three tools of monetary policy--open market operations, the discount rate, and the reserve requirements. The Board of Governors of the Federal Reserve System is responsible for the discount rate and reserve requirements, while the Federal Open Market Committee is responsible for open market operations. Using the three tools, the Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and thus alters the federal funds rate, which is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight (See FRB website). As mentioned above, the Fed sets the U.S. Monetary policy by utilizing the three tools of open market operations, the discount rate, and the reserve requirements. In the case of open market operations, the FRB sells or buys Treasury securities in the open market, usually through financial institutions, in order to affect the money supply in the economy. It sells t government securities when there is inflation or overheating in the economy, and buys securities when it wants to stimulate economic activity. The discount rate is raised when credit needs to be reduced, particularly during inflation, or decreased in order to increase borrowings and encourage business activity. The reserve requirement, a tool seldom used, requires banks to maintain a certain percentage of their deposit liabilities in the form of reserves in their vaults or as deposits with the FRB. The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. The objectives of U.S. monetary policy are price stability and sustainable economic growth. The Federal Open Market Committee (FOMC) consists of twelve members--the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one- year terms on a rotating basis. The rotating seats are filled from the following four groups of Banks, one Bank president from each group: Boston, Philadelphia, and Richmond; Cleveland and Chicago; Atlanta, St. Louis, and Dallas; and Minneapolis, Kansas City, and San Francisco. Non-voting Fed presidents attend the meetings of the Committee, participate in the discussions, and contribute to the Committees assessment of the economy and policy options. Annually the FOMC holds eight regularly scheduled meetings where it reviews economic and financial conditions, determines the appropriate stance of monetary policy, and assesses the risks to its long-run goals and objectives. The current members of the FOMC are * Principal Members o Ben S. Bernanke, Board of Governors, Chairman o Timothy F. Geithner, New York, Vice Chairman o Elizabeth A. Duke, Board of Governors o Richard W. Fisher, Dallas o Donald L. Kohn, Board of Governors o Randall S. Kroszner, Board of Governors o Sandra Pianalto, Cleveland o Charles I. Plosser, Philadelphia o Gary H. Stern, Minneapolis o Kevin M. Warsh, Board of Governors * Alternate Members o Charles L. Evans, Chicago o Jeffrey M. Lacker, Richmond o Dennis P. Lockhart, Atlanta o Janet L. Yellen, San Francisco o Christine M. Cumming, First Vice President, New York Federal Reserve Bank Rotation on the FOMC: Committee membership changes at the first regularly scheduled meeting of the year. 3. Go to the the Web site that offers Federal Reserve News and Events. Follow the "Press Releases: Monetary Policy" link and read the most recent "FOMC statement." What is the FOMCs recipe for monetary policy? Explain why you do or do not support it. A. Statements by the Federal Open Market Committee and the Board of Governors on the stance of monetary policy and on related procedural matters, for September 2, 2008 The statements cover the meetings and decisions of both lthe FRB and the FOMC. Summaries and excerpts are shown below: Minutes of Board discount rate meetings, July 7 through August 4, 2008: 1. Discount and advance rates -- Requests by two Reserve Banks to increase the primary credit rate; requests by ten Reserve Banks to maintain the existing rate. Decision on July 7, 2008: Existing rate maintained. 2.Subject to review and determination by the Board of Governors, the directors of the Federal Reserve Banks of Kansas City and Dallas had voted on July 10, 2008, to establish a rate for discounts and advances under the primary credit program (primary credit rate) of 2-1/2 percent (an increase from 2-1/4 percent). At this meeting, no sentiment was expressed in favor of considering the primary credit rate, and the existing rate was maintained. 3. The directors of the Federal Reserve Banks of Boston, Cleveland, Richmond, St. Louis, and San Francisco had voted on July 24, and the directors of the Federal Reserve Banks of New York, Philadelphia, Atlanta, and Minneapolis had voted on July 31, to maintain the interest rate. 4. Discount and advance rates -- Requests by three Reserve Banks to increase the primary credit rate; requests by nine Reserve Banks to maintain the existing rate on July 21, 2008. 5. Federal Reserve Bank directors recommending a 25-basis-point increase in the primary credit rate agreed that real economic activity continued to be soft and that financial markets had not yet fully stabilized. However, they cited indications that higher input costs were being passed through to product prices and that inflation expectations had risen, and judged that the upside risks to inflation were of greater concern than the downside risks to growth. These directors concluded that an increase in the primary credit rate was appropriate in these circumstances. No sentiment was expressed for changing the primary credit rate before the Committees meeting, and the existing rate was maintained (Press Release of August 4) B. Minutes of the Federal Open Market Committee, August 5, 2008 (Summary/excerpts) A meeting of the Federal Open Market Committee was held in the offices of the Board of Governors of the Federal Reserve System in Washington, D.C. The information reviewed at the August meeting indicated that the economy expanded at a moderate pace in the second quarter, but recent financial market developments highlighted some of the stresses that the economy faced going forward. Real personal consumption expenditures (PCE) rose modestly in the second quarter Residential construction activity continued to descend rapidly but at a somewhat slower pace than during the second half of last year. The U.S. international trade deficit narrowed in May, as a large increase in exports of goods and services more than offset a moderate increase in import. At its June 24-25 meeting, the Federal Open Market Committee (FOMC) kept its target for the federal funds rate at 2 percent. The Committees statement noted that recent information indicated that overall economic activity continued to expand, partly because of some firming in household spending. In their discussion of the economic situation and outlook, many FOMC participants noted that recent developments suggested that economic activity was likely to remain damped for several quarters. Although economic growth in the second quarter had apparently been boosted by fiscal stimulus, resilience in consumption spending even before tax rebates were distributed, and robust gains in exports, recent indicators pointed to a near-term deceleration in household spending and to softer export demand. Economic activity expanded in the second quarter, partly reflecting growth in consumer spending and exports. However, labor markets have softened further and financial markets remain under considerable stress. Tight credit conditions, the ongoing housing contraction, and elevated energy prices are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth. Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated. The Committee expected inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain. The Federal Open Market Committee continued to seek to maintain the federal funds rate at an average of around 2 percent. It stated that “although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability." The writers views on FOMCs stances on monetary policy. This writer believes that the FOMCS method of decision making on monetary policy is sound, based on majority vote rather than consensus. The decisions shown above demonstrate the committees conservative stance with regard to the interest rates, refusing to increase the rates for fear that it would dampen economic activity which has been moderate. On the other hand, reducing the interest rate would serve to fuel inflation, which is being avoided in view of increasing prices of energy and certain commodities. The proposed increases of 25 basis points is very minimal and seemed to indicate that the FOMC tried to avoid giving the wrong signals to business and to the stock market. By maintaining the interest rate at the conservative level, the signal given was that the economy was stable despite high input and energy costs. 4. What countries currently use the Euro? What do these countries hope to gain through using a common currency? The Euro is the national currency of the EU member states who have adopted it, including Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. Together, these countries create what is called the Eurozone, a region where the euro serves as a common national currency for all of the separate nations. Although Maastricht obliged current members to join the Eurozone, the United Kingdom and Denmark negotiated exemptions from that requirement for themselves. Sweden turned down the euro in a 2003 referendum, and has circumvented the requirement to join the euro area by not meeting the membership criteria. Although not legal tender in Denmark and the United Kingdom, the euro is accepted in some stores throughout both countries, particularly international stores in large cities, and shops in Northern Ireland near the border with the Republic of Ireland where the euro is the official currency. The United Kingdom has an opt-out from eurozone membership under the Maastricht treaty and is not obligated to join the euro. (Investopedia). The European Central Bank has been responsible for the monetary policy of the European Union since the adoption of the Euro in 1999 .On its debut as the common currency in the European Monetary Union (EMU) group of nations, the Euro replaced the ECU and the initial value of the Euro was fixed at a one-to-one equivalence with the ECU. Euro-denominated currency and coins went into circulation on January 1, 2002, replacing all national currencies. Benefits and Advantages The advantages of a common currency consist in the removal of exchange rate risks for businesses and financial institutions operating in an increasingly globalized economy. It would at the same time facilitate financial transactions among businesses and individuals of these countries, removing the uncertainties created by fluctuations of exchange rates prevalent during the period prior to the adoption of the European currency. There are some drawbacks, however. Individual member countries may need to formulate their own monetary policies, and not rely on the the European Central Bank, to address specific or unique issues affecting their economies. The official economic justification for the Euro was that a single currency would promote cross-border trade within Europe and international trade with the rest of the world. Converting to a single currency also helps companies cut costs and promotes a more efficient banking system because businesses would no longer have to conduct business in several different currencies (See Banking dictionary) The most obvious benefit of adopting a single currency is the removal from trade of the cost of exchanging currency, theoretically allowing businesses and individuals to consummate previously unprofitable trades. The reduction in cross-border transaction costs would also allow larger banking firms to provide a wider array of banking services that can compete across and beyond the area. Another effect of the common European currency is that differences in prices—in particular in price levels—should decrease. Similarly, price transparency across borders should help consumers find lower cost goods or services. Also, low levels of inflation are the hallmark of stable and modern economies. Bundesbank is independent of the pressures of national governments and has a mandate to keep inflationary pressures low. Member countries join committed to lower inflation, hoping to enjoy the macroeconomic stability. It must be emphasized that the ECB, unlike the US Fed, does not have a second objective to sustain growth and employment. A new reserve currency The euro is widely perceived to be a major global reserve currency sharing that status with the U.S. dollar (USD), albeit to a lesser degree. The euro has become the second most widely-held international reserve currency after the U.S. dollar. 5. Go to the FairTax Web site. Describe what this method of taxation is and how it works. Discuss why you feel this taxation method would or would not encourage saving. The FairTax plan is a comprehensive proposal that replaces all federal income and payroll based taxes with an integrated approach including a progressive national retail sales tax, a prebate to ensure no American pays federal taxes on spending up to the poverty level, dollar-for-dollar federal revenue neutrality, and, through companion legislation, the repeal of the 16th Amendment. (See Fairtax website.) The FairTax Act (HR 25, S 1025), a nonpartisan legislation, seeks to abolishes all federal personal and corporate income taxes, gift, estate, capital gains, alternative minimum, Social Security, Medicare, and self-employment taxes and replaces them with one simple, visible, federal retail sales tax administered primarily by existing state sales tax authorities. A microeconomic study and analysis of the proposed change has indicated that the FairTax seeks to simplify the tax structure, removing the tax on savings and investment and lowering the effective marginal tax rates throughout the economy. It has much lower effective tax rates. Lower marginal tax rates create significant and positive incentives for individuals to both increase their work effort and to report work effort that are currently performed but not reported. Another primary benefit is its impact on savings and capital development. While the current tax code penalizes savings by taxing it excessively, thus diminishing the incentives for US residents to save, the FairTax, being a consumption-based tax, removes these disincentives, eliciting significant dynamic impacts that will raise the savings in the US. It is a marked improvement over the current tax system, eliminating the adverse incentives and producing beneficial incentives in their stead. It will stimulate work effort, work demand and subsequently higher wages. It will promote greater savings and consequently greater capital appreciation. More specifically, the following benefits, among others, are foreseen to accrue to consumers: 1. It enables workers to keep their entire paychecks 2. It enables retirees to keep their entire pensions 3. It refunds in advance the tax on purchases of basic necessities. Compliance costs will be less than current compliance costs in excess of $200 billion and reduction of informal activities as more activity that is not reported becomes recognized. BIBLIOGRAPHY Baldwin, Richard and Charles Wyplosz, The Economics of European Integration, New York: McGraw Hill, 2004. ."euro." Investopedia. Investopedia Inc., 2000. Answers.com 05 Sep. 2008. http://www.answers.com/topic/euro "euro." Dictionary of Banking Terms. Barrons Educational Series, Inc, 2006. Answers.com 05 Sep. 2008. http://www.answers.com/topic/euro euro." Wikipedia. Wikipedia, 2008. Answers.com 05 Sep. 2008. http://www.answers.com/topic/euro Fairtax website. Retrieved September 5, 2008 http://www.fairtax.org/PDF/MacroeconomicAnalysisofFairTax.pdf ________. Retrieved September 5, 2008 http://www.fairtax.org/site/PageServer?pagename=about_basics_main Read More