The Role of Fed in the Current Economy - Essay Example

? Federal Reserve Bank The Role of Fed in the Current Economy The financial crisis the country is trying to come outfrom was a creation of the Federal Reserve. However, the politician has been attacking each other and blaming the Bush administration for poor policy. It is worth noting that the collapse of the mortgage market was necessitated by Fed lax on the money market. The Federal Reserve addresses the economy by regulating financial institutions, setting monetary policies and operating the countries payment systems. Therefore, in pursuing these functions Fed aim to stabilize prices and attain maximum employment. The Federal Reserve tightened it policy after the country suffered from a 2008-2010 financial crisis. Moreover, the bank increased regulations in the financial sector to check on bank lending behavior that caused the housing bubble to burst. These measures have achieved tremendously as indicated in the recent Beige Book. The economy at a national level is growing, and this shows that the country is on the path out of the financial crisis. The Board says that consumer confidence has increased, and business buoyancy is rising too. The Beige Book (2013) reported that the national economic conditions have expanded during the month of September to October. All the twelve Federal Districts had similar rates of growth, though some like Richmond, Philadelphia, Kansas and Chicago showed slowed growth rate as compared to earlier reports. Moreover, the Districts were optimistic of growth in future economics behaviors, but they also feared uncertainty as a result of increased debate on the debt ceiling and government shutdown. The country has increased consumer spending and people are travelling more in all most all the districts. Furthermore, tourism has also increased, and businesses are now growing. This can be attributed to increased payrolls in many Districts. The Fed reports that there is increased demand for manufacturing activities and nonfinancial services. Residential construction has resumed, and it is increasing pace by pace. The lending rate has remained modest, and there was little change in the financial balances. The agricultural sector has been affected, and most districts reported that drought impacted the sector. The energy sector has expanded, but there has been reduced production of coal. Therefore, the overall price condition and wage was stable and without pressure (Board of Governors of the Federal Reserve System, 2013). Economic Indicators That Guide In Stabilizing the Economy Economic indicators are voluminous statistics of the economic conditions that are used by the government in measuring and evaluating the growth of the economy. There are many economic indicators and each function differently from the other. Some indicators have short term effects on the economy while others have short term and long term effects. These indicators include real gross domestic product, money supply, consumer price index, consumer confidence, employment rate and housing starts. Real GDP help the Federal Reserve to know how it will utilize monetary policies to the changes in the economic conditions. Its shows the market cost of a countries goods market produced at the current period. Real GDP shows the country’s wealth by demonstrating the returns on capital and the growth of profit in businesses and service industries. Real GDP, therefore, measures the well being of a country economic activity. Consequently, Fed must use tight monetary policies to ensure that the interest rate is not below the set target of 2%. Low interest rates render the Federal Reserve policies ineffective in controlling the money supply (Labonte, 2013). Employment is the other economic indicator the Federal Reserve ought to address to maintain the path of economic growth. The employments statistics are derived from the payrolls, retail trade, construction and manufacturing and are used in determining the level of unemployment and the well being of the country. Increase in wages enhances consumer spending. Moreover, increasing wages has a spiral effect of increasing inflation. Therefore, Federal Reserve has to balance the effect of wage rate to minimize any increment in inflation. Fed should ensure that the labor market is not tight so as to avoid wage inflation. Money supply is a set of liquid assets that individual, corporate, government and businesses uses in payments of goods and services and also for short-term investments. In the U.S currency, savings in bank deposits and money in checks accounts represent the supply of money. Money supply is defined in two ways, M1 which is a total of all currency along with reserve balances while M2 is the sum of M1 and savings deposits. According to Friedman, money supply determines the course of a country economy and determines the price level and long term inflations rate. Fed uses money supply to adjust the money in circulation, in the country, through open market operation and reserve ratio monetary tools. To ensure sustained growth, the fed ought to buy government securities and increase on the reserve ratio (Board of Governors of the Federal Reserve System, 2013). Consumer price index indicator measures sampled goods and services that consumers spend their disposable income. It is used to measure inflation and is what the Federal Reserve Bank relies on when measuring the country’s level of inflation. Outcome of the analysis of consumer’s price index may prompt the Federal Reserve to change on its monetary tools and policy. Monetary Policies and Money Supply In order to increase or decrease the money supply, the Federal Open Market Committee uses open market operation to foster it function in ensuring stable prices and full employment. Open market operation is a domestic affair, but it also extended to foreign bank, as well. Some are permanent while others are temporarily achieving a long term and short term gains (Board of Governors of the Federal Reserve System, 2013). The Fed sells and purchase Treasury securities, debt securities and GSE MBS under agreement to buy back or resell at a later date. The mandate to trade OMOs is given to Trading Desk by the FOMC. The Federal Reserve sells security when there is excess money in circulation and buys securities to reduce the money supply in the market. Money supply is also influenced by Discount Window. These are short, and long run credits advanced to financial sectors by the Federal Reserve Bank. Moreover, the Federal Reserve also under certain arrangements with other central banks does provide liquidity to foreign banks. Banks that undergo liquidity strained have the opportunity to apply for more funds from the central bank. Therefore, the Federal reserve have the discretion under the economic condition of the country to give more fund and thus increase on the money supply or deny banks funds when it wants to reduce on the money in circulation. From 2003, Fed introduced a variety of discount window, which includes seasonal, secondary and primary credit (Board of Governors of the Federal Reserve System, 2013). Primary credit is advanced to the financial institution with little administrative requirements with an interest rate higher than FOMC’s target. Secondary credit discount window is provided to financial institutions that do not oblige or fail to qualify application for primary credit. Seasonal credits are short-term loans offered to small deposits taking financial institutions. Secondary credit attracts rates based on the market value (Board of Governors of the Federal Reserve System, 2013). Comparison of Fiscal and Monetary Policies and Their Effectiveness The money market and the goods market policies are used to influence the overall spending of a country. Nevertheless, the two policy measures have significant differences worth analysis. The economic activities change so often, and policy makers are worry of how to address the fast changing economic environment. Monetary policy requires frequent changes, and these are evidenced by frequent meeting of FOMO’s member which is twice in a year. However, fiscal policy requires review in after a longer period of about a year or even more. In a period of five years from 2001 to 2006, interest rate was changed 29 times while tax cuts were done only three times (Labonte, 2013). This can be explained by the process in which decisions are made. Tax changes require professional and political approval while interest changes are done instantly by the FOMO’s. Fiscal policies are undertaken towards one direction only. The political spectrum employs fiscal policy and neglects the monetary policies which at a time are supposed to go hand in hand. This has weakened monetary measures operation in the economy. For the past 7 decades, the budget has been on deficit only, but in five years. The federal debts have increased a hundred folds and the Federal Reserve has at time increased and lowered interest rate. Monetary and macroeconomic policies differ in their long run consequences. Expansionary fiscal policies increase the federal debt and thus burden the future generations (Labonte, 2013). The debt that is used to finance current spending will be paid by young generation at a cost higher than the principal amount. Therefore, their incomes will be lower than what it ought to be, and future investment will be ‘crowded out.’ Monetary policies have no effect on future generational equity. Capital inflow of a nation renders monetary and fiscal policies ineffective. For example, increasing spending through budget deficit raises the interest rate. Therefore, the international market would consider investing in economies that have a high return on investment. Imports, therefore, would increase, and the country would suffer from low consumption of local goods. Moreover, exports minimize in comparison the imports and the economy experiences a trade deficits. The gain as a result of expansionary policies is thus cancelled out by trade deficit (Labonte, 2013). Fed reductions of interest rate have the opposite results. Reduction of interest rate will attract domestic companies to invest in foreign countries that have high interest rate. This will increase the exports in relation to imports, and there would be a trade surplus. Therefore, foreign investment magnifies the monetary expansionary policy. Lastly, fiscal policy as well as monetary policy can be targeted to individual or a sector in the economy. The government uses stimulus package to boost promising sector of the economy that are in need. However, the stimulus may be used as a political tool and affect the macroeconomics purpose. Monetary policy tough can be used discretionary to some sectors of the economy, it is usually accidental rather than intentional like fiscal policies (Labonte, 2013). Effect of Monetary Policies used by Fed Monetary policies have short and long run effect on the good market. The short term effects of monetary policies affect inflations and the market for goods and services. According to FOMC the Fed continued to buy MBS to ensure inflation is consistence with the set target and assist the economy to recover. Moreover, the FOMC began to purchase long term Treasury securities. The combined measures aimed at reducing interest rates, broadening the money supply and helping the mortgage markets. The Federal Reserve offer Discount Window to regulate the interest rate in the short run and even in the long run. In October 2013, the Federal Open Market Committee maintained a federal rate of zero to 0.25% (Federal Reserve, 2013). The extension of lending at this rate to the financial institution aimed to trigger an increase in the output production. Furthermore, low interest rate in a short run influences borrowing and long run investment. For example, the mortgage rate and corporate bond bonds has remained low because the Fed has maintained a statutory rate below 2%. This has increased spending on the housing sector and reduced unemployment to a certain extent (Board of Governors of the Federal Reserve System, 2013). Monetary policies, therefore, are essential measures that guide the economic growth of a country. Low federal rate increases the demand for services and goods which in return pushes wages and costs of other products higher. High aggregate demand necessitates demand materials and labor that increases productions. Conclusion The functions of the Federal Reserve are indispensable in maintaining the current momentum growth of the economy. It has maintained low interest rate and tightened regulation in the financial sectors to prevent loosened loan to risky businesses. Therefore, one can say that it is effectively performing it roles. References Board of Governors of the Federal Reserve System. (2013) .What is the money supply? Is it important? Retrieved from http://www.federalreserve.gov/faqs/money_12845.htm Board of Governors of the Federal Reserve System. (2013). How does monetary policy influence inflation and employment? Retrieved from http://www.federalreserve.gov/faqs/money_12856.htm Board of Governors of the Federal Reserve System. (2013). Monetary Policy Tools. Retrieved from http://www.federalreserve.gov/monetarypolicy/bsd-monetary-policy-tools-201303.htm Federal Reserve. (2013). Discount Window: Payment System Risk. FOMC Statement. Retrieved from http://www.frbdiscountwindow.org/ Labonte Marc. (2013). Congressional Research Service. Monetary Policy and the Federal Reserve: Current Policy and Conditions. Retrieved from http://www.fas.org/sgp/crs/misc/RL30354.pdf Read More