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Monetary Policy - Essay Example

Monetary Policy Countries all over the world are regulated by a government that consists of different departments that carries out various functionssuch as building infrastructure, providing benefits to its citizens, giving opportunities to the unemployed etc. One of these important functions includes the regulation of money supply in the country. This is dealt by the monetary policy of that particular country that has its limitations and demand serious attention from not only the policy makers but also the public who would have to follow these policies. Money supply is governed by the Monetary Policy. But before explaining the Monetary Policy, one needs to understand money and its real purpose. Realizing the value of money is just as simple as being thirsty and not even having a single drop of water to drink. How are we going to survive without water? How are we ever going to get what we want? The answer lies in the basic drop of water that may act even as a penny and help us get rid of our thirstiness. Hence, in our developed world of today, money is undoubtedly one of the necessities of life that is significant and very much required for our survival. For our endurance though it may be through food, clothes or keeping the status symbol, money is an obligation. The purpose of money is to make easy the exchange of values among community and between different people. In older days barter system was used which was the trading of things and services in a very limited and cumbersome method

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of exchange. But through this method are 2 buffalos worth a 1 acre of land? How are you going to have that 1 acre of land for 2 buffalos? It is clear that money is a source of wealth creation. Each human being desires for a good health, enough food and shelter though it may be in the form of a house, clothes, or even social security. All these things are considered the basic provisions of life. Therefore, money is the only source by which one can earn the necessities of life. This shows the importance of money which cannot be denied in any case. The money supply governed by the monetary policy is undertaken by the Central Bank. It controls the money supply by increasing it when rates are high and there is little or no growth in the economy and also further reducing it when inflation is high. Further more, The Federal Reserve has tools to govern the money supply as it has the authority to change reserve requirements. A reserve requirement is the percentage banks must keep in there vaults of their total loan portfolio. It manages the money supply, firstly, by lowering the reserve requirement through which the banks increase their leverage and lend out more. Secondly, it changes the interest rates on the money it lends to other commercial banks. Banks are discouraged to lend because of the higher interest rate that makes money more expensive. Lowering interest rates causes the opposite effect. Thirdly, it may expand or contract the supply of money by buying/selling bonds in open market operations (OMO). The growth and volume of lending and interest rates attached to bank borrowing and loans, the value of bank stock, the bank deposits are affected by these OMO’s. The Federal Reserve can easily manage the funding the bank has at any given time and the volume and growth of bank deposits. The supply of paper money can be decreased by electronically debiting it and swapping it with a different financial instrument such as foreign currency, government bonds, or gold. ( David G. Mayes, 2007) For the United States, three categories of assets have been defined as “money” and labeled as M1, M2, and M3. Unfortunately from 1990 to 2007 these aggregates have not been consistently linked to money spending therefore, not being the major focus of monetary policy. Instead, the Federal Reserve implements monetary policy by putting a limit or rather setting a target for an overnight interest rate called the federal funds rate. Rates going upward indicate monetary tightness whereas rates going downwards are taken as a sign of monetary ease. The fluctuations in the short-term interest rates are due to the changes in the federal funds rates primarily, and through these changes money spending is affected too. The U.S. economy is emerging from the worst recession since the Great Depression of the 1930s. “The sliding twirl in the United States began with the housing crisis, which led to the financial crisis. This lead to the some disastrous consequences in which the production collapsed, employment tumbled down and the financial markets froze. This recent recession was the longest and deepest since the dark days of the Great Depression. As the statistics say that the production from the industries fell 17 %, which was the largest decline since 1939, whereas employment fell more than 6 percent, which is again a post-depression record. During the recession there was a loss of nearly 9 million jobs which led the unemployment rates to rise from even below 5 % to more than 10 %. In addition, the value of U.S. homes also decreased and in some areas even more than 30 %. This decrease in economic activity also had adverse effects on underlying consumer price inflation, which dropped from about 3 % in late 2007 to 0.5 percent in the middle of 2010.( Sandra Pianalto,2011) Therefore, the actions of the Monetary Policy are focused on establishing programs to provide liquidity to financial markets and to get credit flowing again. In order to deal with this situation the Federal Reserve purchased $1.7 trillion worth of mortgage-backed securities, government agency debt, and Treasury securities which resulted in lowering the long term interest rates. Further a second round of large-scale asset purchases was also done in order to support economic activity and strengthen economic growth and reduce the risk of inflation lessening below zero for a sustained period. Consequently, the balance sheet expanded enormously, from roughly $900 billion before the crisis to approximately $2.6 trillion today. The Federal Reserve also lowered its short-term interest rate target from September 2007 to December 2008, known as the federal funds rate target, from 5? percent to effectively zero which remains zero even today. The Federal Open Market Committee (FOMC) revealed some important results which indicated that the economic recovery is taking place at a moderate pace. As more and more industries and organizations are hiring people and adding workers. These indicators point to stronger job growth in the future. Also, household spending and business investment in equipment and software also continues to inflate.  Consumer spending has shown more strength than what was predicted in the past. These are good signs that the recovery is going towards an upright direction. There has been an increase in the prices of energy and other commodities which have enlarged the inflation bracket in recent months.  Growth in retail sales and business demand are largely supported by rising employment, incomes, and profits which shows that there would be further growth in employment, incomes, and profits. There has been a strong growth not only in exports but also in manufacturing and business investment in equipment and software which has supported the recovery of the economy tremendously. “Exports have matured at a double-digit rate since the recession ended and manufacturing production has grown at an annual average of 8 %. During the recession there was a collapse of trade but now the exports and manufacturing is being recovered which is a part of the recovery of the global recovery of trade. The speeding up in U.S. exports has been led by a range of goods, including automobiles and parts, industrial and computer equipment. “(Sandra Pianalto,2011) To promote a stronger pace of economic recovery and to help ensure that inflation rate is stable FOMC would also be expanding its holdings of securities. It would regularly review the composition and size of its securities holdings and would adjust those holdings as needed to best foster maximum employment and price stability. It would also maintain the target range for the federal funds rate at 0 to 1/4 percent and continue to monitor the economic outlook and financial developments. The committee may also come up with an idea in which it would adopt an explicit numerical objective for price stability and maximum employment. This would increase the likelihood that the FOMC would have to lower the short-term interest rate and make it equal to zero for an extensive time to head off a deflation or to fulfill its required order for maximum employment. But problem arises when keeping interest rates near zero complicates the monetary policy process. Therefore, it may be unwise to establish a corresponding numerical objective for the Federal Reserve. The long run sustainable rate of unemployment moves around for different reasons. The reasons could be the demographic makeup of the population or even changes in how labor markets function. The sustainable level of unemployment is unknown to everyone including The Federal Reserve and no one is aware of the fact that how it will evolve over time. Therefore, The Federal Reserve should not go for numerical objectives of unemployment.( David G. Mayes, 2007) The U.S. economic expansion is still quite rough, and it has substantial ground to make up. History suggests that the effects of recent commodity price pressures on consumer price inflation are likely to be transitory. But in reality the economic conditions, including subdued inflation trends, low level of resource utilization, price stability and unemployment rate, warrant the continuation of the current monetary policy stance. Hence, The Federal Reserve should complete their asset purchase program as scheduled, and should keep the federal funds rate target at unusually low level for a comprehensive period. The signs are not that bad. Although in part of the effects of the Japanese earthquake and tsunami in March had caused disruptions which had made some manufactures and investors pessimistic about US economic recovery as the oil prices also experienced a hike. But the decision of the Congress has paid attention towards reducing the budget deficit instead of tax cuts or new spending that might encourage economic activity. The critics believe that the Middle East turmoil and demand in fast-growing countries like China is the cause of the higher oil prices and food-price inflation is mainly due to crop shortages caused by bad weather. Hence, the actions of monetary policy seek to foster maximum employment and price stability.  Therefore the monetary policy of US should focus on devising strategies and tools for decreasing unemployment rate and boosting the economic growth. Further this would not only provide opportunities to the unemployed but would also help to cover up the losses incurred in the recession period. References: Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue N.W., Washington, D.C. 20551 David E. W. Laidler ,Money and Macroeconomics, Edward Elgar Publishing, 1997 Ralph T. Byrns, Gerald W. Stone, Macroeconomics, Scott, Foresman, 1989 David G. Mayes, Open market operations and financial markets, Routledge, 2007 Sandra Pianalto, President and CEO, Federal Reserve Bank of Cleveland, Global Interdependence Center Conference: Capital Markets in the Post-Crisis Environment, April 7, 2011: http://www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2011/Pianalto_20110407.cfm
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Monetary Policy Countries all over the world are regulated by a government that consists of different departments that carries out various functions such as building infrastructure, providing benefits to its citizens, giving opportunities to the unemployed etc…
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