Introduction
The Federal Reserve System or Bank acts as the United States Central Bank. Founded in the year
1913, it was mandated to provide the country with a sound, safe, stable and a flexible monetary
and financial system.
- Evaluate the role and the effectiveness of the Federal Reserve in stabilizing the current
economy.
The Federal Reserve has four major roles and functions in the country’s financial and monetary
system. It controls the country’s monetary policy by stabilizing the monetary and credit
environment and conditions in the country’s economy while pursuing and targeting maximum
employment, average long-term interest rates and stable prices. The Federal Reserve also
controls, supervises and regulates the country’s commercial banks to ensure all the legal banking
insurance regulations and laws are implemented to ascertain the country’s safety and financial
soundness of the country’s banking system is protected including the rights of the consumers.
The Federal Reserve also stabilizes the financial system and maintains its stability while
avoiding all the systematic risks that can develop in the financial markets. It also provides much
needed financial services to all the depository institutions in its jurisdiction including the major
and main role of operating and maintaining the country’s payment systems.
2 Federal Reserve: Fiscal and Monetary Policy
The main component of the Federal Reserve is its arm of Federal Open Market committee
(FOMC) that is charged with the major role of overseeing the open market activities and
financial operations in the market. The Federal Reserve uses this tool to influence the overall
market performance including the monetary and credit conditions.
The Federal Reserve is an independent bank whose decisions cannot be influenced by
anyone not even the president of the country and its decisions don’t need anyone’s approval or
ratification. The Federal Reserve is subject to an oversight authority by the U.S. Congress. It
operates within the framework and guidelines established by the government that sets the
objectives of the economic and financial targets and policies of the government.
The structure of the Federal Reserve gives it a grip on the whole economy and on all economic
activities in all parts of the country. Its system is made up of the central and governmental
agency together with the Board of Governors in Washington and twelve regional Federal
Reserve Banks spread all over the country.
The Federal Reserve’s Board of Governors, whose members total six in numbers among them
chairman and vice chairman are the president’s appointees approved by the Congress. It also has
about one thousand eight hundred (1800) members of staff across the U.S. The Board supervises
and regulates all the operations of the Reserve banks maintaining the country’s payment system
and governs, administers the laws and regulations regarding the protection of the consumer credit
system. (www.federalreserve.gov/publications/)
FOMC establishes the policies regarding the open market operations but the Board of the
Federal Reserve Bank has the final say in any changes in the reserve requirements and has to
approve any changes in discount rates which the Bank initiates.
3 Federal Reserve: Fiscal and Monetary Policy
The Board regulates and supervises the U.S. entire banking system and also exercises
supervisory authority over state chartered banks that are also members and part of the Federal
Reserve System, the companies that own banks in the U.S., the activities of foreign banks in the
U.S., the Edge Act and the agreement Corporations.
- Determine which economic indicators the Federal Reserve should analyze so it can better
stabilize this particular economy.
An economic indicator is economic statistic that allows analysis of the economic performance
and subsequent predictions of the future performance. (Emrys, 2009)
Monetary aggregates have been preferred as economic indicators on the grounds that they have a
stable relationship with the economy which is relatively fair compared with the other indicators
and it can be controlled reasonably with the Central Bank, either by supply of balances or rates at
the Federal Reserve. For instance, if the Federal funds rate increases (together with other short
term interest rates) it will discourage the attractiveness of holding the money balances instead of
or relative to the higher yielding instruments of money markets and reduce the demanded amount
of money and the gradual growth of the money stock. The money stock measures are the
transaction dominated M1 and other broader ones like M2, M3 and liquid balances that have
different behaviors.
Gross Domestic Product (GDP) is another indicator that indicates the performance of the
economy. The rate of growth in terms of expansion of money over time would be similar or
equal to the nominal GDP growth as implied by inflation objectives and the real growth in
4 Federal Reserve: Fiscal and Monetary Policy
GDP. For instance if the target of inflation is 1% and the real GDP rate of growth related to
maximum employment goal is 3% then the indicators of growth in money stock is 4%.
Interest rates also serve as economic indicators not only because of the functions they play in
making spending decisions but also because of the availability of information on interest rates
on real time basis. The relative level of interest rates will fluctuate with the level and stance of
the fiscal policy, patterns of consumption, productivity growth, household and general business
spending patterns and the economic developments within the country and abroad.
The slope of the yield curve is also an indicator of the monetary policy i.e. the actual
difference between the short term and long term interest rate instruments. For instance, a yield
curve with a positively steep slope (i.e. longer term rates of interest are above the interest rates
that are short term) and may be an indicator that the participants or the potential investors in the
bond market believe that the monetary policy is somehow too expansive and inflationary.
Alternatively, a downward sloping yield curve (the short term rates are more or higher than
longer rates) indicates a very restrictive risking unnecessary loss of output and employment.
The yield curve is affected by other factors among them prospective fiscal policies,
developments in the foreign exchange markets and the future expectations of the monetary
policy paths. (www.federalreserve.gov/publications/)
The Taylor, named after the popular economist John Taylor is another indicator that the
monetary policy makers rely on to determine the performance of the economy. It refers to the
setting of the reserve funds rates to the initial primary goals of the monetary policy. For
instance, one type of the rules suggests that the federal rates of the fund be set at a rate equal to
or consistent to the long run together with the overall achievement of the targeted full
5 Federal Reserve: Fiscal and Monetary Policy
employment and the price stability plus the component based on the real gap between the
current level of inflation and the objective of the inflation less any component based on the
actual shortfall of output from the maximum employment level. When the rate of inflation is
picking up then Taylor rule suggests the actual amounts and the rate that Federal reserve rates
should be raised or if the employment and the overall output is reducing then there is a
prescribed amount by which the rates should be lowered.
Foreign exchange rates are important indicators of the performance of the economy besides
they are directly affected by any changes in monetary policy and they react promptly.
- Describe which monetary policies the Federal Reserve might use to influence the money
supply.
Interest rates are the rates at which borrowed money is paid back to the lender by the
borrower. This interest rate is a percentage of principal sums paid over and above the amount
borrowed. Interest rates are the critical tools for monetary policy control and are heavily relied
upon when dealing with such variables like unemployment, investments and inflation. The
government through the Federal Reserve Bank reduces interest rates to encourage and increase
investment and money supply in the general economy.
Interest rates in most instances affect savings and the general money supply inversely.
That is, there is a negative state of correlation between money supply and the interest rate. When
interest rates rise the average household saves more to make use and take advantage of the high
interest and consumes less out of their current income as they prefer to save most of it. Savings
can also be considered as be considered as postponed investments. The rate and growth of
investments is a major indicator of the amount of money in circulation
6 Federal Reserve: Fiscal and Monetary Policy
People will only save if they are paid much more than what they currently need. In short,
in the long run, the higher the interest rate the less savings will occur as businesses will pass the
high cost of borrowing to the consumers who will eventually reduce their spending habit which
will lead to a drop in sales and result in losses for the companies who will react by retrenching
some employees leading again to less consumption because of lack of income and a recession
will definitely set in because of these circle of events. For instance, when the consumer financing
increased their cost due to an increase in interest rates it highly discourages the use of credit
cards The long term interest rate usually reflects and shows what people in the financial
market expect from the Federal Reserve Bank to do in future. If the people’s view is that the
Federal Reserve Bank is not doing enough to control and maintain the supply of money, they
will add a premium risk to long term rate as a provision to shield them against the expected
increase in inflation. These will push the interest rates further higher and also the supply of
money will also increase. The inflation premium is the provision for expected effects of inflation
expected by the investor given the prevailing economic conditions.
- Explain the strengths and weaknesses of using monetary policy in comparison to fiscal
policy when promoting economic activity and preserving price stability.
The interest rates are the tools of the US monetary policy that influence all kinds of
financial and economic decisions people make i.e. whether to buy a house or a car or start up a
business. The main aim of adjusting the interest rate is to influence the way the economy is
performing which is mainly reflected and revealed in such factors as inflation, GDP, and
employment. It affects the demand of goods and services across the entire economy. This
demand is the people and firms’ ability and willingness to spend and increase consumption.
Adjustments in interest rates are used to adjust, control and maintain inflation within an
7 Federal Reserve: Fiscal and Monetary Policy
acceptable limit for a sound and healthy economy in order to spur economic growth. When
implementing the monetary policy through adjustment of interest rates i.e. increasing or
decreasing the rates to affect or alter people and company’s demand for products and services.
Also the outright purchase and repurchase of securities plays a big role in the monetary control
process.
Monetary policy is only one of the factors that have effect on a country’s output; others are
employment and commodity prices. The economic status of ordinary households and businesses,
and also the aggregate demand and also aggregate supply. These factors can be built by spending
habits or consumption, can be anticipated, or can be decided under economic decisions while
others come as a surprise. The government makes decisions that affect the economy through
changes in taxes and other spending programs which apparently receive a lot of public attention
that builds a lot of anticipation before they are implemented. For instance the effect of tax cuts
will be felt even before its implementation. The anticipation created about the tax cuts will affect
the businesses and households as they will reduce all their activities drastically while hopping to
gain from the lower taxes that are about to be implemented.
The financial markets builds fiscal events into levels and structures of the prevailing
financial markets that stimulates such measures like the tax cuts making the levels of interest
rates to raise even before the tax cuts become effective which results in a restraining effect or
influence on demand and the overall economy even before the fiscal financial stimulus is
applied.
Some changes in aggregate demand and the subsequent supply can be very unpredictable
and affects the economy in ways that can’t be anticipated by even the Federal monetary agency.
8 Federal Reserve: Fiscal and Monetary Policy
For instance the shocks on the demand side are actually shifts in the consumer and the business
confidence and the general changes in the lending patterns of the commercial banks, creditors
and other financial institutions. Reduced confidence regarding the conditions of the economy and
the general labor market or the restrictive prevailing conditions actually tends to discourage
business and household consumption or spending habits. Natural disasters, disruptions and
fluctuations in the oil market that interfere and reduce the supply, losses in the agricultural
sector, and reduced productivity are instances of negative supply shocks that can’t be influenced
or controlled by the country’s monetary policies. This type of shocks raises prices and reduces
output. Monetary measures can only attempt to counter the losses of output or the effects of
higher prices but cannot actually offset both the influences.
Monetary policy makers and the economic council have limited access to up-to-the-minute
information on the working and the state of the economy and the current prices. The availability
and use of key data and its regular revisions can be of great use if it’s received on time. Though
the monetary policy makers eventually offset the negative effects of the demand shocks, the
period taken to reverse the effects is considerable making the prices to depart from the required
path.
The set statutory targets of maximum employment, steady and stable prices are achievable if
the public understands the objectives and targets of the Federal Reserve and believes in the
effectiveness of its actions. But in most cases the public is less inclined to reduce spending and
consumption because of the assumption that the demand may not be as strong as expected to
warrant new investments or household goods because of poor job prospects.
9 Federal Reserve: Fiscal and Monetary Policy
- Analyze the effect of the Federal Reserve’s action you identify in No.3 on aggregate
demand/supply model.
Changes in the real interest rates influence the public’s demand for the products and
services mostly by adjusting the costs of borrowing, the loans available for investors, the rates of
foreign exchange, the wealth and purchasing power of the average household in the economy.
For instance, when there is a decrease in the interest rates it lowers the cost of interest for the
loan borrowed which allows businesses and large corporations to increase investments and
further leads to more spending on durable goods by average households in the economy.
The low interest rates and the favorable economy increases the average commercial banks
reserves which leads the banks to encourage small businesses and households to take loans by
offering good borrowing terms and low interest rate. These increases spending habits especially
for the average income earners who opt for the banks as a source of credit. ( Sullivan and
Sheffrin, 2003)
Low interest rates make the common stock and direct investment more favorable and
attractive than bonds which results in the increase in common stock prices. Households and
companies with stocks and similar investment experience a higher value in their holdings which
increases wealth and boosts them to spend more. This increase in the value of stocks also
encourages and makes it attractive for small and big firms to invest in plants and equipment by
the issue of stock.
The low interest rates in the US, in the short run, reduces the value of the dollar in the foreign
exchange market that lowers the average prices of the goods manufactured in the US which are
10 Federal Reserve: Fiscal and Monetary Policy
being exported and sold abroad while the imports prices increase i.e. goods manufactured abroad
and sold in the US become more expensive. (Deventer, Imai and Mesler, 2004)
When there is an increase in general spending the rate of consumption also increases. These
also increases demand for the output of the economy. The companies in the economy have to
increase production and also employment, which also raises the level of spending on durable
goods. Due to the increase in employment, demand is also boosted further.
Wages and prices will eventually begin to rise at an increasing rate if the monetary policy
stimulates and favors the combined demand and pushes labor and the capital markets over their
long term capabilities or capacities. A monetary policy that is persistent at maintaining low short
term real interest rates will eventually lead to a high rate of inflation and also increased nominal
rates of interest without any permanent and effective increases in the corresponding growth and
output or any meaningful drop in unemployment levels. Output and unemployment rates are
rarely directly affected by the monetary policy in the long run as the tradeoff between the high
inflation and unemployment rates in the short run is eroded and disappears in the long run. These
affects consumption as when inflation increases the value of the dollar decreases making it
cheaper for foreigners to invest in the US market. These investments lead to more employment
opportunities which increase consumption in the US. (Deventer, Imai, and Mesler, 2004)
For instance in the year 2008 and parts of 2009, when the US economy recorded a negative
8% growth, www. research.stlouisfed.org/publications/iet/, the employment level during that
period was at an all time low which stood at negative 4% growth while unemployment was at
10%. The composite of long term government bonds stood at 4.5% while the three months CDs
11 Federal Reserve: Fiscal and Monetary Policy
stood at slightly over 3% that nose dived to almost 0.1% in 2009 while the GDP was at its lowest
negative growth of 4.5%.
The health and state of the economy also affects interest rates and consumption by
influencing the supply and demand for credit. When the economy is a recession, the general
income of the average household reduces and the amount of saving also reduces by the same
margin. The need for credit by businesses generally reduces in a recession as most companies
spend less money on new investments, buildings, equipment and stocks these is due reduced
demand by the general public which leads to very low consumption of goods and services.
During this period the interest rates are normally excessively high and the Federal Reserve will
most likely reduce interest rates to encourage economic activity which eventually will lead to
more demand.
The federal government also needs credit during recession as the low demand and reduced
business activities, i.e. low investment, reduced expansion in fixed assets and capital expenditure
leads to reduced tax revenues while other spending on unemployment insurance increases, the
pressure for the government to act also increases. This compels the government to reduce its
interest rates charged on commercial banks to expand and create more credit facilities to the
public. These will attract borrowing which will again lead to more aggregate demand.
Wages and aggregate demand are interrelated which are tied to employment. Without
employment demand will be negatively affected. The existence of the decreasing trend in the
nominal wage difficulties bends and affects the short run wage Philips curve. The slopes and
curvature of the Philips curve is influenced and depends on the level of inflation and the nature
of the original wage rigidities. When analyzing the US wage and employment changes from the
12 Federal Reserve: Fiscal and Monetary Policy
great recession, it reveals that the decreasing trend of the original wage difficulties have shaped
the dynamics of unemployment since the year 2006 to the year 2012, these trends have also
affected the aggregate. ( Sullivan and Sheffrin, 2003)
References
Deventer, D., Imai, K., Mesler, M. (2004). Advanced Financial Risk Management, An
Integrated Approach to Credit Risk and Interest Rate Risk Management. John Wiley & Sons
Sullivan , Sheffrin, S (2003). Economics: Principles in action. Upper Saddle River, New Jersey
Pearson, Prentice Hall.
Emrys, S. (2009) ‘Economic Indicators,’ in Wankel, (ed.) Encyclopedia of business in Today’s
World, California, USA,
