Evaluation of the Role and the Effectiveness of the Federal Reserve in Stabilizing the Current Economy - Essay Example

? The Federal Reserve Evaluation of the role and the effectiveness of the Federal Reserve in stabilizing the current economy The Federal Reserve System is the central banking system of the United States that is responsible for ensuring stability in economic conditions and monetary flow in the economy. Over the years, the system and structure if the federal reserve has evolved to meet the effects of economic crisis and great depression in the economy. The Federal Reserve System was created under the Federal Reserve Act in order to address the issue of panic in the banking industry and acts as the final check point and regulator in the clearing system and the banking industry. The effectiveness of the role of the Federal Reserve System lies in the monetary policies of the bank. The responsibility of designing appropriate monetary policies is bestowed on the Federal Reserve System by the Federal Reserve Act in order to ensure availability of money and liquidity in the economy and to arrange for provision of affordable cost of credit in order to fulfil the national economic goals. The monetary policies of the Federal Reserve System are aimed at sustaining the level of productivity and create a balance between the supply and demand. The responsibility of the Federal Reserve System also encompasses controlling of inflation rates by fixation of appropriate interest rates in the financial system. The basis of the monetary policies of the Federal Reserve System lies in the inter bank lending policy (Mankiw, 2011). During the phase of revival from the period of recession in the current economy, the Federal Reserve System modified its monetary policies in order to boost consumption demand in the economy by undertaking policies to inject sufficient flow of funds. The interbank rates depend on the Federal fund rate which is determined by the Federal Reserve System. The interbank rate at which the banks lend each other for overnight loans is influenced by the Federal Reserve System through several tools like the open market operations, discount rate and the reserve deposit requirements of the central bank. The open market operations determine the rate at which the US securities and treasury bonds are transacted in the market. This influence the inter bank rates which determine the liquidity in the economy. The discount rate is determined by the Federal Reserve System looking at the demand of the economy and providing credits to the banks in required rates to fulfil the demand of liquidity in the economy. The reserve fund requirements are the deposit base held by the banks as a statutory requirement with the Federal Reserve System. The decrease in the reserve requirement as determined by the Federal Reserve policy would help to inject more liquid funds into the economy. The current economic conditions which showed a financial crisis led to the need of increased direct lending by the banks and financial institutions (Allen, 1999). The Federal Reserve System played an important role in determining appropriate inter bank rate to encourage increase in lending for the business. This has been done through increase in open market operations by the Federal Reserve System that has led to the increase in the flow of liquidity ion the economy. A higher level of production in the current economic conditions has created the stage for revival of the economy. This in turn has led to the rise in income levels of the people thereby boosting the spending in the economy. As the banking system was severely hit during the current economic recession, the Federal Reserve System adopted measure to increase the credit to organisations other than banks. The central bank engaged in liquidity swaps with the other central banks of other countries. The usage of derivative products raised giving hope to the recovery of economic conditions. Thus the roles and responsibilities of the Federal Reserve System have been highly significant in establishing a position of stability for the current economy. It is through the policies of the Federal Reserve System that the liquidity crunch in the economy has been recovered and this helped to raise the consumption demand of the economy which finally led to the increase in the productivity of the units to produce a higher gross domestic product. Consideration of economic indicators by Federal Reserve to stabilize economic conditions The Federal Reserve System considers key economic indicators in order to identify the situation of economic recession and undertake appropriate measures for stabilizing the economy. The key economic indicators considered by the Federal Reserve System include the consumer price index, per capita income of the nation, unemployment rate, inflation rate, balance of trade, etc. The economic indicators considered by the Federal Reserve System provide a true picture of the current economic conditions. This helps the Federal Reserve System to undertake policies to stabilize the current economic conditions. The consumer price index provides an indication of the market prices of goods and services purchased by the household sector. A fall in the consumer price index indicates that the goods and services are being sold in the market at reduced prices. Such a situation would tend to arise when the consumption demand of the economy would fall and the sellers would be forced to reduce their prices in order to reduce he inventory and sustain their flow of revenues. The consumer price index is determined by the US Bureau of Labour Statistics which is used as a reliable source by the Federal Reserve System. The consumer price index was at 224.83 index point in July 2011 which increases to 231.48 basis points in April, 2013. Looking at increasing the consumer price index, the central bank revised its monetary polices to boost the demand of the economy for which the index rose in the subsequent stages. The increase in consumer price index reflects the stabilization of the current economic conditions as the decrease in demand of the economy has been revived. The Federal Reserve System also keeps note of the inflation rates of the economy. A rapid increase in demand against the supply would lead to high rise of the prices of goods. This would lead to inflation in the economy. The inflation rates are thus indicators to the Federal Reserve System in order to maintain a balance between the supply and demand in the economy. The inflation rate was as high as 3.8% in September, 2012 which was brought down to 1.1% in April, 2013. Thus inflation rate has been considered by the central banks to revise their policies for stabilizing the economy. This has led to the balance of supply and demand in the current economy. The per capita income of the economy gives an indication to the central bank of US about the average income level of the population that decides the spending in the economy. The spending would affect the production. Thus the per capita income of the nation influences the GDP per capita of the country which is an important economic indicator for the performance of the economy. The GDP per capita of US rose from 46349.12 US dollars in 2008 to 48441.56 US dollars in 2012 with intermediate hiccups showing that the Federal Reserve System has adopted policy measure to increase the productivity and demand of the economy. The unemployment rates are other important indicators considered by the Federal Reserve System. The unemployment rates depict the stability of the livelihood of people in the economy and thus provide a measure of the demand of the economy. The unemployment rate decreased from 9% in June, 2011 to 7.5% in April, 2013. This shows that the central bank of US gives due importance to the economic indicators and adopts necessary strategies to stabilize the current economic conditions. Monetary policies the Federal Reserve might use to influence the money supply The Federal Reserve System undertakes effective monetary policies to influence the money supply in the economy of the country. The monetary policies include variation of interest rates and use of various financial instruments and derivatives by the central bank of US in order to vary the flow of money in the economy as per the demand. Considering the current economic conditions of recovery from the financial crisis, the Federal Reserve System would effectively manipulate the inter bank lending rate to boost production in the economy. The central bank would thus be able to make credits available to the productive units required to boost the production. The interbank lending rate is the basis of the monetary policy. The Federal Reserve System would sale and purchases US treasury securities and bond to the banking system and the finance industry at designed rates in order to inject additional funds to the organizations. These funds would in turn be used for providing credits to the productive units. The increase in production and income level would help to boost the demand of the economy (Mishkin, 2007). The central bank may also adopt the policy of varying the discount rates at which they lend to the commercial banks. This would help to inject liquidity in the commercial banks and provide freedom for offering credits. The Federal Reserve statutory deposit amounts to be maintained by the banks could also be varied by the central banks in order to adjust the flow of money in the economy by allowing the banks and the finance industry to hold more funds for usage. The strengths and weaknesses of using monetary policy in comparison to fiscal policy There are inherent strengths and weaknesses for using monetary policy in comparison to the fiscal policy as measures adopted by the Federal Reserve System in order to foster economic activity and growth and at the same time stabilize the prices of goods. The fiscal policy is related to the spending and revenue collection of the Federal Reserve System. In a situation of decreased demand in the economy, the Federal Reserve may step in to increase government spending or lower taxes to make more liquidity available in the economy. The monetary policy on the other hand includes revision of interest rates and the Federal Reserve statutory requirement to improve the flow of money in the economy. The strengths of monetary policy would be that through effective measures, the central bank would be able to increase the flow of money in the system thereby leading to the rise in the consumption demand which would boost the production in the economy. The weakness of the monetary policy adopted by the central bank lies at the conflicting objectives of the central bank in achieving economic stability and controlling inflation. A revival of economic demand would tend to raise the prices of goods and services. With increase in demand above supply, the price of the goods and services would rise beyond control leading to inflation (Marshall, 2006). Again, a deflation in the economy would give rise to unemployment rates. Thus the monetary policy needs to be revised periodically in order to avoid its inherent weakness. Analysis of the effect of Federal Reserve’s action on the aggregate demand / supply model The Federal reserves action in stabilizing the economic conditions by adopting ways to inject liquidity in the economy would affect the demand and supply model of the economy as a whole. As a result of the monetary policies of the Federal Reserve System, the income level of the people would rise due to increase in employment. The circular flow of money encompasses the firms, the households and the government as the players in the economy. The increase in liquidity and income level of the population would revive the demand in the economy and as result the productive units would tend to spend more on their units of production. The availability of credit in order to fund the production processes would lead to the increase in supply of goods and services to meet the increase in demand. Thus an increase in aggregate demand in the economy as result of the effect of monetary policies of the central bank would give rise to the increase in aggregate supply. The aggregate supply would increase in order to meet the increased aggregate demand of the economy. This would lead to stabilization of the current economy as a whole. References Allen, R. E. (1999). Financial Crises and Recession in the Global Economy. Great Britain: Edward Elgar Publishing. Mankiw, G. (2011). Principles of Economics. Stamford: Cengage Learning. Marshall, A. ( 2006). Principles of Economics. Washington: Osprey Learning. Mishkin, F. S. (2007). Monetary Policy Strategy. USA: MIT Press. Read More