The Federal Reserve System - Term Paper Example

Introduction The current economic situation is considered as one of the worst economic period in the history of United s of America. Starting in the end of 2007, economic downturn has resulted into the decline in GDP level, an increase in the unemployment as well as reduction in the consumer credit due to low consumer confidence and spending. The persistent decline in the economic activity therefore attracted the attention of the Government as well as the Federal Reserve System. Government took both the fiscal as well as monetary measures in order to stimulate the economy.

These events however, led Federal Reserve System or FED to intervene into the economy in order to take some measures to correct the economic situation. FED as the central bank of the country not only provided emergency support to the Banks and financial institutions but it also initiated different structured programs in order to stimulate the economy and bring back the economic situation under control. Some of the steps taken by FED include reduction of the interest rates, changes in the different targets as well as the process of quantitative easing.

These steps were taken in order to ensure that the basic goals and objectives of a central bank are fulfilled. It is also important to understand that FED also undertook some of the unconventional measures also in order to ensure that the economic recovery is quick and stable. This paper will discuss the recent events and actions and relate them to the basic principles of macroeconomics. Reduction in Interest Rates Central Banks can exercise different options in order to intervene in the economy and bring in the desired changes.

Two of the most important changes include changes in discount rate and the open market operations. Through open market operations, a central bank actually purchases or sells government securities in order to increase or decrease the liquidity in banking sector. (Krugman and Wells). The overall purpose is to control the flow of credit in the economy according to the overall current situation. Another important step taken is change in the discount rates wherein a central bank reduces the discount rate i.e. the rate at which banks can borrow from central bank.

By increasing or decreasing the discount rates, central bank actually increases or decreases the interest rates and hence controls the flow of money within economy. The above graph is showing the changes in the FED rate from 1952 to 2009. FED has drastically reduced the rates from 2007 onwards.1 FED reduced the interest levels in the economy to very low levels – almost touching zero at the beginning of the current economic crisis. During 2008, interest rates reduced to 1% and the same were further reduced in order to stimulate the consumption activity.

By reducing the interest rates, FED actually attempted to make credit cheaper so that households can borrow money at low rates and consume the same. It is important to understand that FED set the target of keeping the interest rates within the range of 0 to 0.25% in order to provide the necessary stimulus to the economy in terms of increasing the household consumption activity and increase industrial output Quantitative Easing Quantitative easing is another rather unconventional tool used by FED in order to stimulate the economy.

Quantitative easing as a monetary policy tool is adapted when traditional methods such as reduction in the interest rates and open market operations fail to yield satisfactory results. (Wesbury and Stein) Under this process, a central bank tends to purchase financial assets from the financial institutions through money which is created electronically. The overall aim is to create an artificial flow of money into the system and increases the excess reserves held by the banks besides increasing prices of the financial assets.

By increasing money supply in the economy, FED therefore attempted to remove the concerns for liquidity in the market created as a result of credit crunch. Conclusion Federal Reserve System took two important steps in the wake of the current economic crisis in order to ensure that economy remains on track. By lowering the federal fund rate or discount rate, FED made borrowing cheap so that household consumption could be increased besides increasing the overall demand for the consumer credit. These steps were primarily taken in order to reduce the unemployment level and increase the output within the economy.

What is also significant to understand that overall purpose of FED during current economic crisis also remained focused on saving the whole financial system of the country also. Since most of the heavy weights of the financial industry collapsed therefore there was an strong probability for the overall collapse of the whole financial system of the country. Bibliography 1. Krugman, Paul and Robin Wells. Macroeconomics. New York: Worth Publishers, 2009. 2. Wesbury, Brian S. and Robert Stein. The Myth And Mistake Of Quantitative Easing.

28 September 2010. 29 June 2011 .