The Federal Reserve Example

The Federal Reserve

Introduction:

The Federal Reserve or the fed is the institution within the United States that plays the role of a central bank in many other states across the globe.

The Federal Reserve was formed by an act of congress in 1913. Its main objective was to provide the nation with a more secure, flexible, and more stable monetary and financial system. The Federal Reserve is not only restricted to formulating the monetary and financial policy but also is also involved with the general formulation of policies within the government sector. This is usually so, so that the government ministries do not implement policies that may override the projections set forth by the Federal Reserve. Over the years, the fed has seen the economy through the great depression, the two world wars as well as guiding the economy to become the largest economy in the world.

The fed is an autonomous branch from direct executive control and this permit the fed to make and implement its own independent decisions. Just like in any other economy, the central bank is meant to provide the economy with a reliable and efficient monetary policy by ensuring the prevalence of a predictable and stable currency, a bearable interest rate as well as reliable float of narrow and broad money.

Although the monetary policy is formulated independently, it cannot be implemented successfully without the existence of a supporting fiscal policy.

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The Federal Reserve

ANALYSIS:

Central banks, the fed being apart of them usually have some economic tools that they use to achieve their goals these include reserve ratios, open market operations, discount and federal funds rates. These tools can be used independently or collectively depending on the intended changes within the economy.

Although these tools usually have almost identical direct effects, the ultimate re alignment within the economy is what makes either of the tools a better policy tool depending on the nature of the economy. In times of booms or recessions, the monetary policies implemented will not have the same effects. In addition if the government is pursuing a contractionary or expansionary fiscal policy will also cause the monetary policy tools used to have different sectoral impacts.

Open market operations (OMO):

Open market operations involve activities like selling and buying of government bonds or treasury bonds. The sale of treasury bills to the banking sector or to the public is usually meant to reduce money supply in circulation while the purchase of the same from the public is meant to increase money supply. When the public purchases the treasury bonds, they actually pay up the money to the government. Once the money is paid up, the money supply in the economy reduces by the equivalent amount. By doing this, the Federal Reserve may have intended to raise the interest rates.

Once the supply declines money, the cost of getting money (interest) increases. Interest can be simply described as the cost of money. When the Federal Reserve increases the prevailing interest rates, this usually discourages borrowing. Once borrowing is reduced then the level of money supply within the economy is proportionally reduced by the level of the increase in interest rates.

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Reserve requirements:

The reserve requirements refer to the proportion of private deposits that the Federal Reserve requires commercial banks to deposit with the fed. To increase or reduce the money supply within the economy the Federal Reserve either reduces or increases this ratio respectively. In addition changing the reserve requirement directly affects the money multiplier that determines the amount of money that commercial banks can convert into loans within their existing deposits.

The federal funds and discount rates:

Over the last decade, the fed has increased its focus on the central funds rate (the interest rate charged by commercial banks on over night lending) as a primary indicator of a stance of monetary policy. To accomplish this, the fed announces a federal funds rate target of each F.O.M.C meeting.

By regulating the over night lending rates the federal reserve indirectly regulates the money supply since the general prevailing interest rates will actually rise or fall depending on whether the fed intended either of this to happen. By regulating the federal funds rate, the fed also implements changes that may or will reduce challenges for banks to get loans but at the same time, it may hamper the availability of the funds by raising the price of the loans.

Unemployment rate and types of unemployment (frictional, structural, and cyclical), or business cycle:

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Frictional unemployment is the kind of unemployment that exists as workers move from one industry to another. Structural unemployment on the other hand exists because of changes in technology and thus some people find themselves jobless since their skills are not required any more.

In addition, people may find themselves jobless if the sector they work in is affected by business cycles. This may include the tourism sector where you may find that tourists come either in the summer or in winter. In formulating the monetary policy, the Federal Reserve needs to analyze the effects of these policies on the different kinds of unemployment, and seek ways to reduce it.

In formulation of the monetary policy, the fed also needs to put in to consideration the nature and size of the unemployment rate existing within the economy. This ensures that the fed can implement a monetary policy that will lead to increased performance in certain sectors of the economy.

Unemployment usually leads to higher inflation, a key issue that the monetary policy that the Federal Reserve seeks to minimize. In avoiding this, the fed has to calculate the inflationary cost of low unemployment as well as the unemployment cost of low inflation using the Phillips curve. This will be decided and analyzed based on fixed expectations, adaptive expectations and rational expectations.

Gross Domestic Product (GDP):

The nature and size of the gross domestic product also needs to be analyzed. This is because a good monetary policy, is supposed to lead to the enhancement or growth of gross domestic product. An expansionary monetary policy will lead to increased growth of GDP since the increased money supply will lead to increased investments. On the other hand, a contractionally

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The Federal Reserve

monetary policy may lead to a decline in output not unless it is supported by an expansionary fiscal policy. Irrespective of this scenario, an expansionary monetary usually has an adverse effect of stimulating a rise in the rate of inflation.

Despite the use of these economic tools, there are some economic features that the Federal Reserve must have in order to be more effective in its operations. Since we know, the major goals of the monetary policy are full employment, price stability, currency stability and economic growth.

The credibility of the Federal Reserve needs to be assured so that the Federal Reserve does not always have to resort to using the tools but all it needs to do is ask the private sector to behave in a certain way to achieve its desired objective. If the private sector views the Federal Reserve as a credible institution then the private se4ctor will cooperate and implement the desired changes to avoid the Federal Reserve from going ahead and imposing punitive measures. With this, kind of a scenario then the Federal Reserve only needs to announce its intended changes and the private sector will only have to operate in the intended way.

Due to unforeseen circumstances, for example changes in the price of key imports like oil, or catastrophes like hurricane Katrina or the September 11 terrorist attacks. In such cases, the outcome is usually the tendency for the rate of inflation to go up. In such cases, the Federal Reserve sometimes finds itself faced with a problem whereby it cannot safeguard the interests of all citizens or accomplish all its goals.

Under such situations it might choose either to cut down inflation at the expense of a higher unemployment rate or do the vice versa.

In using either of these tools, the Federal Reserve aims to set up a stable monetary policy. Before deciding which economic tool to use, the fed usually conducts an analysis for the market

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of both the bonds and reserves. In addition the foreign exchange rate is very crucial since it also influences the net outflow or in flow of dollars into the economy.

To employ all these tools and come up with a reliable monetary policy close partnership with fiscal policy formulators is crucial. This is because the fiscal policy, through taxation indirectly regulates money supply since increased taxation reduces disposable income that is usually targeted by the federal reserves when formulating the fiscal policy.

Conclusion:

For the Federal Reserve to be able to use the economic tools available at its disposal and formulate a monetary and financial policy that is not only stable but also safe and flexible, then the formulation of the monetary policy needs to be done in close collaboration with the treasury. This is meant to assure the fact that the monetary policy will compliment the fiscal policy while at the same time the fiscal policy will also compliment the monetary policy.

Further more the monetary policy is usually hampered by not only domestic price shocks but also scenes on a global perspective. Issues of terrorist attacks on American assets or installations overseas also hamper the effectiveness of the monetary and financial policy since instances of capital outflows or inflows may be more intense than the fed might have anticipated. Although the Federal Reserve may limit credit creation within the local economy chances are always available for commercial banks as well as the private sector to be advanced loans from overseas either from their parent companies or from other financial partners using collateral securities.

References:

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Ahmann Tim, Federal Reserve Okays major changes to bank lending, retrieved on 22 June 2007. Available at: http://www.oregontcboysbb.org/articles/macro2/ahmann103102.html

Federal reserves’ inflation vigilance persists…, retrieved on 22 June 2007. Available at:

http://www.oregontcboysbb.org/articles/macro2/cnn102105.html

GDP reading boosts futures: Broad …, retrieved on 22 June 2007. Available at:

http://www.oregontcboysbb.org/articles/macro2/cnn102805.html

Samuelson

Robert J, It is Not Your Dad’s Oil Story …, retrieved on 22 June 2007. Available at:

http://www.oregontcboysbb.org/articles/macro2/samuelson102605.html

http://www.oregontcboysbb.org/articles/macro2/will102505.html

The Federal Reserve official website available at: http://www.federalreserve.gov