The Federal Reserve and Macroeconomic Factors - Essay Example

Topic: The Federal Reserve and Macroeconomic Factors By The Federal Reserve refers to a system of federal banks charged with regulating the U.S money supply through use of Federal Reserve tools such as setting the discount rate and buying U.S securities. The Federal Reserve has the great responsibility of keeping the United States economy on track and running smoothly. To do so, they have three main tools at their disposal in order to affect changes in the monetary policy. Their most important tool is the buying and selling of securities on the open market. This allows the Federal Reserve to control the amount of money that is in the supply, enabling them to affect the amount of reserves commercial banks maintain. The other two tools, adjustment of the reserve ratio and the discount rate, also affect the overall money supply, however, not as effectively as the open-market operations Introduction The Federal Reserve refers to a system of federal banks charged with regulating the U.S money supply through use of Federal Reserve tools such as setting the discount rate and buying U.S securities. Therefore, the Federal Reserve is like an economic sentinel who implements policies designed to keep the country operating smoothly.  The Federal Reserve is headed by a Board of Governors of the Federal Reserve. The Board of Governors consists of seven presidential appointees, each of whom serves 14-year terms. All members must be confirmed by the Senate and can be reappointed. The board is led by a chairman and a vice chair, each appointed by the President and approved by the Senate for four-year terms.  The Federal Reserve is the bank of the U.S government it controls and regulates the financial institutions and watches over the world’s largest economy therefore its economic and monetary policy dictates have a huge impact on individuals in the U.S and the world at large Significance of the Study The Federal Reserve controls the economy of the United States through a variety of tools. They use these tools to shape the monetary policy of the United States in order to promote economic growth and reduce the rate of inflation and the unemployment rate. By adjusting these tools, the Federal Reserve is able to control the amount of money in the supply. By controlling the amount of money, the Fed can affect the macro-economic indicators and steer the economy away from runaway inflation or a recession.  Federal Reserve tools The Federal Reserve uses three main tools in order to control the money supply. These tools are; a. Open-market operations. b. Reserve ratio c. Adjusting the discount rate a. Open-market operations. These operations consist of the buying and selling of government bonds to commercial banks and the public. Open-market operations are the most important tool that the Federal Reserve can use to influence the money supply (Brue, 2004, p. 252). By buying bonds from the open market, the Federal Reserve increases the reserves of commercial banks, which in turn will increase the overall money supply in the country. The opposite is true if the Federal Reserve sells bonds on the open market. By doing so, the Federal Reserve reduces the reserves of banks and, in turn, takes money out of the system. By being able to control how much money the commercial banks can lend, the Federal Reserve has a very powerful tool to adjust the economy. b. Reserve ratio The reserve ratio is the ratio of the required reserves the commercial bank must keep to the bank’s own outstanding checkable-deposit liabilities (Brue, 2004, p. 254). By raising and lowering the ratio, the Federal Reserve can control how much the commercial banks can lend. For example, if the Federal Reserve lowers the reserve ratio, commercial banks will now have excess reserves allowing them to lend more money to businesses or individuals. Vice-versa, by increasing the ratio, the Federal Reserve forces the banks to lend less money due to having smaller excess reserves. If the bank is deficient for reserves it has, the bank is forced to reduce checkable deposits and, subsequently, reduce the money supply. It may also need to increase its reserves by selling bonds, which would also lower the money supply (Brue, 2004, p. 274).  c. Adjust the discount rate. The discount rate is the interest rate at which the Federal Reserve charges commercial banks for a loan (Brue, 2004, p. 274). By issuing the loan to the commercial bank, the Federal Reserve increases the reserves of the borrowing bank, which allows them to issue credit to the public. Depending on which way the Federal Reserve adjusts the rate either encourages or discourages commercial banks from obtaining a loan. A decrease in the rate encourages banks to obtain loans from the Federal Reserve Banks. With the additional reserves, the banks can lend more to the public, also increasing the money supply. The opposite happens if the Federal Reserve decreases the discount rate.  Macroeconomic indicators The three main macro-economic indicators the Federal Reserve looks at are a. Real Gross Domestic Product (GDP for short) b. Inflation Rate c. Unemployment Rate Each one is affected by changes in the money supply in various ways. a. Real Gross Domestic Product (GDP for short) Real GDP increases when the money supply increases. With more money in the economy, investment and consumer demand rise. This leads to an increase in the Real GDP. Any measure taken by the Federal Reserve that reduces the money supply leads to a decrease in investment and spending which will lead to a decrease in the Real GDP. b. Inflation Rate Although the increase in the money supply leads to an increase in Real GDP, it also leads to an increase in the rate of inflation. If the amount of money in the economy is increased, the real value of money decreases because there is more money purchasing the same quantity of goods and services. As a result, the prices will increase and as will the rate of inflation. c. Unemployment Rate The unemployment rate is inversely related to Real GDP. As GDP increases, investment and spending increase, leading to greater demand and employment opportunities. As employment opportunities increase, unemployment rates drop. When Real GDP goes down, investment and demand will drop leading companies to slow their growth. This leads to an increase in the unemployment rate. Money supply also has an impact on unemployment rate; it is inversely related to Real GDP. As investment spending increases, there will be an increase in employment needs. The fact that there will be a need for an increase in production means that there will be a need for an increase in the labor force. This will eventually lead to a decrease in unemployment rate. Further, money supply in the system will decrease; thus, a decrease in Real GDP will eventually follow.  Effects of Federal Reserve tools The Feds monetary policy actions affect prices, employment, and economic growth by influencing the availability and cost of money and credit in the economy. This in turn influences consumers and businesses willingness to spend money on goods and services. The primary effect of the tools the Federal Reserve can use is to create or remove money from the supply. The money is created primarily from the commercial banks issuing loans to consumers or businesses. The money for the loans comes from the excess reserves the banks have at the Federal Reserve Bank. The Federal banking system is set up in such a way where any excess reserves are magnified into a larger amount of new checkable-deposit money. This is known as the monetary multiplier Conclusion The Federal Reserve has the great responsibility of keeping the United States economy on track and running smoothly. To do so, they have three main tools at their disposal in order to affect changes in the monetary policy. Their most important tool is the buying and selling of securities on the open market. This allows the Federal Reserve to control the amount of money that is in the supply, enabling them to affect the amount of reserves commercial banks maintain. The other two tools, adjustment of the reserve ratio and the discount rate, also affect the overall money supply, however, not as effectively as the open-market operations Recommendations By changing the amount of reserves commercial banks must keep, the Federal Reserve can increase or decrease the amount of money that banks may wish to loan to consumers or businesses. If the banks increase the amount of loans they issue, they also end up creating money. The Federal Reserve, when deciding on a monetary policy, has to balance this increase in money supply and how it affects the economic indicators of Real GDP, inflation, and unemployment. By creating a balanced monetary policy, the Federal Reserve can effectively continue economic growth while lowering inflation and the unemployment rate. Works cited Brue, Stanley L and McConnell, Campbell, R. (2004). Economics: Principles, Problems  and Policies (16th ed.), New York, NY,  McGraw-Hill. Gregory Mankiw’s (2000) Principles of Macroeconomics, 2nd edition Orlando, FL, Harcourt Brace & Company. Federal Reserve Bank of San Francisco (2004), U.S Monetary System retrieved April 9, 2013 from http://www.frbsf.org/publications/federalreserve/monetary/MonetaryPolicy.pdf Read More