The Federal Reserve System and Money Supplies - Essay Example

The Federal Reserve System The Central Banking of the USA is known as the Federal Reserve System (Fed)."It is not owned by anyone and is not a private, profit-making institution. Instead, it is an independent entity within the government, having both public purposes and private aspects" (BOG, 2009). It came into being in 1913 with the primary objective of acting as a lender of the last resort in containing situations of Bank Runs and Panics which were quite frequent in those times (Kubik, 1996). Over the course of time, the Fed s roles have evolved and expanded to cover a significantly broad spectrum (Wells, 2004). The present roles played by the Fed in the economy can be majorly classified into four broad categories of a) conducting USAs monetary policies to attain and sustain highest possible employment, steady price levels and over the long-run, interest rates, b) Supervision and regulation of the various financial institutions to maintain the systems security and ensuring compatibility within activities, c)Ensuring overall financial stability and systemic risk containment and d)Provision of various financial services to the government and other official national and international institutions and administering the national payments system. (BOG, 2009) The Fed is constituted presently of five major operative parts : The Board of Governors, The Federal Open Market Committee, the Federal Reserve Banks, member banks and the advisory councils. Of these, the Federal Open Market Committee is discussed in the next section. The Federal Open Market Committee (FOMC) As one of the most important parts of the Fed, the FOMC is responsible for all the open market operations (essentially, purchase and sales of government securities carried out by the Fed in the open market; to be detailed in the subsequent segment) carried out in the economy by the Fed. The entire process of evaluating the present state of the economy and then deciding upon the suitable interest rate targets and adequate money supply is undertaken by the FOMC. In essence it is the part of the Fed that administers the effective money supply for the nation through open market operations and interest rate targeting. The short run goals for monetary policy are set and the required values of the policy variables are set in accordance by this institution. Through open market operations the key interest rates such as the federal funds rate, i.e., the price charged by commercial banks for overnight loans among themselves, are targeted in the final pursuit of influencing the aggregate demand in accordance to the already set objectives. Certain activities in markets of foreign exchange undertaken by the Fed is also directed by the FOMC although such intervening actions are required to be coordinated with the treasury, which is the institution responsible for all exchange rate policy formulations as lack of co-ordination can be purpose defeating in aggregate. (BOG, 2009) Monetary policy tools: In pursuit of its stated objective of providing “the nation with a safe, flexible and stable monetary and financial system”, the Fed has a set of tools at its disposal. It is not impertinent to note that to attain this goal, the tools are essentially a fundamental set of control variables, or the aspects that can be controlled and in turn influence various aspects of the economy (Mankiw, 2002). Open market operations: The first option, or instrument of influencing the money supply which is also the most direct one is that of open market operations. These directly alters the monetary base of the economy. By influencing the total amount of money in circulation, the Fed can thereby control the aggregate demand. In principle, open market operations are really simple. If the securities are sold, hard cash is withdrawn from the system, while in case of purchases, hard cash is injected in to the system. Thus, if the economy is hit by excess demand initiated inflationary trends, one way to combat it would be to curtail the demand. So, the Fed makes open market sales of government securities. Since these are sold against money, the total amount of money in the system falls and people hold government securities instead. As a result of reduced money, the aggregate spending falls and the inflation is checked. Similarly, facing recessionary trends, the Fed to stimulate demand make open market purchases of securities. As a result, money is injected in to the system and higher spending is induced (This will be explored in further detail in an example in the next section). (Froyen, 1996) Reserve Requirements :The fed requires all banks to maintain a particular ratio of its assets in the form of cash. The higher the proportion is, lesser is the amount of loanable funds available to the banks. Thus, the supply of money in the economy can be controlled by the Fed through increasing or decreasing this ratio. As shall be seen, these ratios have important consequences in the determination of the effective federal funds rate. (Froyen, 1996) Interest rates : The Fed can also contract or expand the money supply indirectly by altering the interest rates which are in essence the cost of borrowing. By setting higher rates, the Fed can choose to make borrowing hard and thus curtail the money supply. The Fed directly sets the discount rate, which is the rate at which the commercial banks can borrow funds from the fed itself and the nominal federal funds rate, which is the rate at which banks lend out to one another. The need for borrowing for banks arises primarily from the necessity of maintaining the reserve requirements. Thus, the effective federal funds rate depends upon the stringency of the reserve requirements implying the efficacy of the reserve requirements in controlling the nations money supply as well (Mankiw, 2002). However, a crucial point to note here is that the Fed can influence the money supply either through interest rate changes or through changing the monetary base but due to the interdependence of these variables, its operations on only one of these can be independent. Thus it must choose one or the other as the targeted policy variable (Poole, 1970). The effect of an open market sales on the Economy: If the fed sells $500 billion in treasury bonds, it would imply a rise in the monetary base of the economy precisely by that amount. Thus the money supply in the economy would rise through the multiplier effect (a mechanism that leads to a magnification of a monetary stimulus; details beyond the scope of this article). Due to this rise in the supply of money, given its demand, the price of borrowing falls. So, there is a substantial reduction in the interest rates banks charge to customers as well as among themselves (federal funds rate). Therefore, investments will be induced thereby leading to an increase in the real aggregate planned expenditure. If the economy was in recession, i.e., operating below full employment this will lead to a rise in output and employment which in turn through secondary effects will enhance the output to grow farther. However, if the economy was already in full employment at the time of the sales, then this rise in demand can lead to inflation as demand will rise but with the economy already at full capacity, only prices will rise. Of course it is unlikely that the Fed would initiate such activities unless the economy was already in a recession or the threat of one loomed large. References: BoG (2009) “The Federal Reserve System: Purposes and Functions, Board of Governors” http://www.federalreserve.gov/ Froyen, R.T., (1996) Macroeconomics: Theory and Policy, Tata-McGraw-Hill Kubik, P J (1996) "Federal Reserve Policy during the Great Depression: The Impact of Interwar Attitudes regarding Consumption and Consumer Credit."Journal of Economic Issues. Volume: 30. Issue: 3. pp 829 Mankiw, H.G (2002) macroeconomics 5th ed, Worth Poole, W., (1976) “Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model” The Quarterly Journal of Economics, Vol. 84, No. 2 (May, 1970), pp. 197-216 Wells, D R., (2004)The Federal Reserve System: A History, Jefferson, NC: McFarland Read More