Federal Funds Rate Research Paper

Pages: 10 (3201 words)  ·  Bibliography Sources: 10  ·  File: .docx  ·  Level: Master's  ·  Topic: Economics

8% in late 1982, which stunted the increase in living standards through lower productivity. High inflation caused the stock market to stagnate and led to a series of debt crisis that afflicted American farmers, U.S. Savings & Loan industry, and developing countries. This was a lesson that showed the high inflation created too much money for too few goods that causes a reverse the in economic growth of the country.

By 1979, there were soaring interest rates, high inflation, and a rising foreign trade deficit that led to an inactive stock market. On July 24, 1979, Paul Volcker became Chairman of the Federal Reserve (Trumbore). Volcker was determined to end inflation. He set a target for money growth, and increased the federal fund rate a full percent to 12%. This caused the Treasury bill yields to grow rapidly and bond values to decrease. By raising interest rates and tightening credit, it caused an economic slump to cut wages and increase supply and demand.

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Bank prime rates had hit 21.5%, mortgage and bond rates rose, industrial production dropped to 12%, prices were rising, and wages decreased causing unions to agree to wage cuts. Volcker changed policies from past practice. Money supply was cut to curb inflation. Volcker proposed the shifting of focus from interest rates to the focus of basic money supply, focusing on M1 currency, which consists of currency, or coins and paper in the hands of the public, and checkable deposits, or all deposits in commercial banks and thrifts or savings institutions on which checks can be drawn. This would give a basic amount of reserves to the banks and through subsequent borrowing and spending would translate into a given amount of money. The idea was to squeeze the amount of money to squeeze inflation where too much money would not be chasing too few goods in an effort to create a noninflationary economic growth.

Research Paper on Federal Funds Rate the Federal Assignment

Volcker implemented credit controls, proposed by President Carter, on bank lending to businesses and consumers, including credit card debt. The controls were supposed to be designed to relieve pressure on interest rates and avoid a recession while maintaining a fight against inflation. The controls did not include home or auto loans and only had modest restraints on credit card borrowing. The effect was a decrease in inflation-adjusted consumer spending and rises in the unemployment rate. This was a lesson learned from weak control policies. It was imperative that the policies have strong controls and be enforced for maximum benefit to the economy.

The Monetary Control Act of 1980, Depository Institutions Deregulation and Monetary Control Act (DIDMCA), Title I extended the Federal Reserve's power to include all depository institutions and the eligible collateral for Fed issue of the Federal Reserve notes. Title II of the act deregulated and allowed all financial institutions to provide checking account services to customers and abolished interest rate controls on deposits. This act invited foreign customers to hold large amounts of U.S. dollars.

In July, 1982, the money supply had reached its target, so the Fed relaxed the credit controls and focused on ending the recession. The discount rate was decreased from 12% to 11.5%, with more decreases by December. The stock market went up 38.8 points. Stocks rose 50% over the next six months as investors moved money from money market funds and saving certificates. Interest rates declined and the economy started to recover. By waiting until the money supply had reached its target, the lowering of the interest rates would have a more lasting impact for the road to recovery, more especially by slow gradual reductions to the point of stability.

By driving interest rates to record highs, Volcker had cut inflation to 4% by 1983 (Madrick). The major blow that Volcker delivered to the U.S. economy caused a deep recession, an unemployment rate to 11%, countless bankruptcies with the closing of businesses, low levels of investment, government loan defaults, and near bank failures. Because Americans had come to believe inflation was indestructible, credibility had to be won by suffering for companies to understand they could no longer raise prices without consequences and workers to understand increasing wages was no longer an option. With Reagan cutting taxes and increasing military spending at the time, Volcker only increased the federal fund rate in small intervals for fear of the federal deficit's inflationary consequences. Volcker only supported campaigns that were anti-inflationary. In 1985-1990, the Fed increased the monetary base to create inflation for economic growth.

A low level of inflation is good to stimulate growth in the economy. But, when the inflation rate rises too high, it creates too much money for the amount of goods produced and creates a decline in the levels of productivity. The declining productivity causes other problems of unemployment, and debt crisis with loan defaults that result with unemployment. This is where the federal funds rate is so important for the economy. The adjustments in the federal funds rate help to keep inflation at appropriate levels in the efforts to avoid and stop problems of high inflation.

Alan Greenspan became Chairman of the Federal Reserve in 1987. Monetary policy had become a widely accepted practice being viewed as an economic lever. The FOMC was powerful and legally independent of the President and Congress. The President and Congress only had direct control when the chairman and the governors came up for reelection. Greenspan's philosophy was that inflation was the central economic concern and the emphasis was on reducing government spending and eliminating the deficit. He felt that the government spending was the source of inflation. He discarded the use of money supply data to determine policy in 1993. He disagreed with Volcker's policies and set out to change them. This brought rapid economic growth as interest rates remained low and unemployment dropped. The banks and bank like institutions were far freer from government oversight and regulatory enforcement than any time since the 1920s.

Greenspan's philosophy resulted in a stock market crash in 1987, a thrifts crisis in 1989, the collapse of junk bonds by 1990, a derivatives crisis in 1994, the Mexican peso collapse in 1994, the Asian financial crisis in 1997, the failure of Long-Term Capital Management and the Russian default debt in 1998, and the severe stock market crash in 2000 (Madrick). Speculation enabled both stimulative monetary policy and regulatory neglect that preceded all the collapses. Speculation rose to dangerous heights. Soaring debt rose to unmanaged levels. Derivative instruments negatively affected Wall Street when the Fed surprisingly raised rates in 1994. In the later 1990s U.S. high-technology stock prices reached unjustifiable levels and in 2000s housing prices rose faster in an attempt by Greenspan to restart a flagging economy after the high-technology collapse.

Greenspan concentrated on a low inflation rate with high interest and slower economic growth. Deregulation of the financial markets was widely supported. When the stock market was crashing, the Fed started buying short-term Treasury securities to provide funds to the banks, encouraging banks to lend, and cutting the interest rates. Only with recession and interest rates on bonds falling was Greenspan willing to cut rates.

To restart the economy he maintained a low-interest policy. As the economy recovered the federal deficit fell. Reducing the federal deficit was the priority. Greenspan kept the federal funds target rate low for almost two years for the economy to recover and the unemployment rate to drop to 6.5%. He then suddenly started raising the rate because there was no inflation at the time. Greenspan viewed any fall in the unemployment rate under 5.5% to be inflationary. He insisted in keeping rates steady instead of raising them. From mid-1998 to the end of 1999, the unemployment rate fell to nearly 4% without stimulating inflation and the Dow Jones Industrials grew by 4,000 points. The government deficit turned into surpluses with tax revenues from incomes and capital gains.

As a response to major international turmoil, Greenspan started raising interest rates. The currencies of Thailand, Korea, Malaysia, the Philippines, and Indonesia fell. Greenspan's raising of the interest rates limited the international crisis. The cause of the crisis was blamed on the deregulation policy of the Clinton administration, which insisted the nations end capital controls. Either way, by Greenspan raising the interest rates, it cushioned investors of foreign coin where they did not receive the full impact from loses created by the falling foreign currencies.

The federal fund rate is an important tool that helps to control inflation in the economy. It is the rate the Federal Reserve uses to focus monetary policy. The federal funds rate helps the Federal Reserve to control the bank reserves, which in turn, determine the lending ability of the banks. By controlling the lending ability of the banks, the Federal Reserve controls other interest rates, such as the prime rate and other interest rates banks charge their customers. The federal fund rate affects the entire financial market as it controls stock prices and prices of other financial instruments, such… [END OF PREVIEW] . . . READ MORE

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"Federal Funds Rate."  Essaytown.com.  August 16, 2012.  Accessed September 22, 2020.