Tools in the Federal Reserve - Essay Example

?Q1: What tools does the Federal Reserve use to control the supply of money? Which is used most frequently? Which is most potentially powerful? Why? The Federal Reserve has several tools at its disposal to control the supply of money. These are: 1) Open market operations: The Federal open market operations refer to the Fed buying and selling securities in the open market. When the Fed buys the securities, the interest rates go down and there is an increase in the money supply in the market and when it sells them, the interest rates go up and the money supply is reduced in the market. 2) Reserve requirement (RR): The RR refers to the minimum percentage of their deposits that banks must keep in reserve at a Federal reserve bank. The higher the RR, the lower the amount of money lent by banks and vice versa. 3) Federal funds rate (FFR): The FFR refers to the rate at which banks lend each other money overnight in order to maintain the reserve requirement. If the FFR is high, banks would be unwilling to lend beyond the reserve requirement and vice versa. 4) Discount rate (DR): The DR refers to the rate that the federal reserve charges the bank if it wants to borrow money from it in case when the money is not available to be borrowed from other banks. The DR is usually higher than the FFR. The open market operations are the most widely used tool for controlling the money supply in the market. The decisions for these open market operations are made during the Federal Open Market Committee meetings which since 1981 have been held 8 times at regularly scheduled times each year. These open market operations change the money supply without impact the money multiplier. The most powerful tool that the Fed has to control the monetary policy is the Reserve Requirement. Changing the RR not only impacts the money supply but also the money multiplier as it directly influences the bank lending. By increasing the RR, as the banks are forced to keep a higher percentage of their deposits with the Federal Reserve rather than lending, the money multiplier is also reduced along with the money supply. Q2: Refer to Figure 15-2 on page 303 of your text. (Redraw the graphs (scale is unimportant) and illustrate a) easy money policy, and b) tight money policy. Explain how both might be achieved in reality. Easy money policy: To fight recessions, the Fed can use its monetary policy tools to increase the growth of money and credit, which tends to lower interest rates and spur growth of the economy. This monetary policy is said to be easy or expansionary. Tight money policy: To restrain inflation, the Fed can use its monetary policy tools to reduce the growth of money and credit, which tends to raise interest rates and slow the growth of the economy. This monetary policy is said to be tight or contractionary. For the easy money policy, first the MS increases which causes the interest rate to decrease which causes the amount of investment to increase. This causes AD to increase leading to a higher real GDP and a little inflation. The implementation in reality is done by the Fed by buying securities from banks and/or reducing the reserve ratio for banks, the FFR and the DR. For the tight monetary policy, first the MS decreases which causes the interest rate to increase which causes the amount of investment to decrease. This causes AD to decrease leading to a lower real GDP and a decrease in price levels. The implementation in reality is done by the Fed by selling securities from banks and/or increasing the reserve ratio for banks, the FFR and the DR. Q3: Comment on the theory underlying the use of a monetary rule by the Federal Reserve. Does the use of such a rule seem appropriate under current economic conditions? Explain. The theory underlying the ue of monetary policy by the Federal Reserve is also known as the Taylor Rule. It is an interest rate forecasting model invented by John Taylor in 1992 and described in his 1993 study called “Discretion Vs. Policy Rules in Practice". In general, the Taylor rule mean that for a 1% increase in inflation, the fed should increase the interest rate by 1.5%. The formula used for the Taylor rule looks like this: i= r* + pi + 0.5 (pi-pi*) + 0.5 ( y-y*). Where: i = nominal fed funds rate r* = real federal funds rate (usually 2%) pi = rate of inflation p* = target inflation rate Y = logarithm of real output y* = logarithm of potential output In the present times, as the US GDP fell by -4%, and the inflation rate went below zero in 2009, following Taylor rule would have meant having an interest rate below 0, which is not a practical option. Some calculations suggest that as per Taylor rule, the interest rates should have been as low as -7%! (Pettinger 2009). Thus, using Taylor rule in such a situation is not practical. Q4: Can monetary and fiscal policies complement each other? Suppose economic policymakers are attempting to stimulate a recessionary economy by raising government spending and lowering taxes. What sort of monetary policy is likely to be appropriate? Monetary and fiscal policies can complement each other. If the government wants to increase the total output, it can implement fiscal policies to increase the output and at the same time deploy expansionary monetary policy to stimulate consumption and investment. Similarly, if the economy is under high inflation, it can reduce government spending and raise taxes and at the same time introduce contractionary fiscal policy to curb inflation. The total output in the economy is the sum of private consumption, gross investment, government spending and net exports. Also, the private consumption decreases with increasing taxes. Now, the fiscal policy impacts the government spending and the tax components of the output while the monetary policy, by changing interest rates impacts directly or indirectly all the other components - the private consumption, the gross investment and the net exports (making local products cheaper or costlier to produce). As the monetary and fiscal policies affect different parts of the output, both policies can complement each other. To stimulate a recessionary economy, the government can increase spending and reduce taxes. However, as the government increases spending, interest rates are likely to increase thereby reducing the private investment. This is also known as the crowding out effect. In order to counter this, a complementary fiscal policy can be introduced to reduce the interest rates thereby stimulating private investment also to increase. Thus, the government can adopt an easy money policy to complement the fiscal policy. This can be done by either increasing the money supply or by directly reducing the interest rates. References Byrns. Student Guide for Learning Contemporary Economics. The Federal Reserve System. Chapter 29/13. P193. Pettinger T. Taylor Rule and Interest Rates. May 2009. Accessed 18 June 2011. http://econ.economicshelp.org/2009/05/taylor-rule-and-interest-rates.html Taylor, John B. 1993. Discretion versus Policy Rules in Practice. Accessed 18 June 2011. http://www.stanford.edu/~johntayl/Papers/Discretion.PDF Read More