Term Paper: Federal Reserve System and Its Control Over US Economy

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Federal Reserve Bank is the central bank, and therefore plays a critical role in the American economy. The Federal Reserve is charged with developing and implementing monetary policy, while Congress and the White House are charged with developing and implementing fiscal policy. Monetary policy is economic policy that relates to the control of the money supply, and the Fed has a number of tools at its disposal that can allow it to exert influence over the money supply. The main areas where the Fed seeks to exert its influence on the macroeconomic environment are in the inflation rate, the unemployment rate and the GDP growth rate. The Fed also conducts a significant amount of research and publishing, in order to improve the amount and quality of economic research and data available to Americans. This paper will primarily examine the monetary policy of the Federal Reserve in order to examine the contribution that the Fed makes to the overall state of the U.S. economy.

Structure and Role of the Fed

The Federal Reserve system is comprised of twelve district reserve banks, plus a Board of Governors. The presidents of each reserve bank make up the Federal Open Market Committee (FOMC) who provide significant guidance for monetary policy in the United States (Federal Reserve Education.org, 2013). The objectives of monetary policy, as outlined by the Federal Reserve (2013), are "to promote maximum employment, stable prices and moderate long-term interest rates." The view is taken that fostering long-term price stability will lead to long-term economic growth and maximum employment. This implies that the Fed is not as concerned with short-term movements in the unemployment rate or the GDP.

There are three primary instruments of monetary policy. They are via the discount rate, open market operations, and reserve requirements. The FOMC sets the discount rate, which is the rate at which the Federal Reserve lends to banks. This affects the supply of money by affecting the cost of money. Banks will adjust the rates at which they offer credit to their customers, based on the discount rate, because the discount rate is publicly-known. The higher the cost of credit, the less business investment there will be in the economy, as well as less consumer investment in rate-sensitive purchases like housing. The overall effect that this has on the economy can be understood in terms of the accounting identity for the GDP, which is GDP = C + I + G + X -- M. Thus, the sum of consumer spending, business investment, government spending and exports, less imports. When the cost of money is higher, both I and C. will be reduced. When the cost of money is lower, both I and C. should increase, barring extraordinary circumstances such as excess capacity that constrains business investment. The reason for this lies with the relationship between the cost of money and the expected rate of return. Businesses generally make investment decisions using capital budgeting principles -- the expected value of an investment is the value of the future cash flows from that invested. These cash flows are worth less the higher the interest rate is. Thus, the higher the interest rate, the fewer investments will be profitable, therefore the fewer investments will be accepted, and the less business investment there will be. It is roughly the same principle with consumers and housing and the anticipation of a slowdown in housing demand is enough to reduce business investment in real estate projects.

In general, an increasing GDP will correlate with lower unemployment and higher inflation. Thus, the Federal Reserve seeks to strike a balancing act between the two, finding just the right level of discount rate to encourage investment, but not so much that the economy becomes overheated and high inflation results.

Open market operations seek to influence the state of the economy by influencing the amount of the money supply, rather than the cost of money. Because the U.S. dollar is a fiat currency, the precise quantity of dollars in the world at any given point in time is subject to the actions of the central bank. The central bank manages the quantity of dollars in the economy via open market operations. It buys or sells Treasury securities in the open market, and that money either enters or leaves the economy. The cost of money is going to relate to the supply of money under normal circumstances, so open market transactions will tend to affect the decision to invest or not invest, especially on the part of business.

One of the new twists on the open market operation is what has come to be known as quantitative easing, which applies the same technique to longer-term Treasuries. The objective in that case is not necessarily to manage the amount of money in the economy, but to manage the expectations for monetary policy. The objective is to drive down the spread between long-term and short-term Treasuries, to make short-term investing more attractive even at very low rates. As the Economist (2013) points out, this is a riskier strategy than conventional monetary policy, and is normally only undertaken during times when short-term rates are pinned closed to zero, such that conventional open market transactions have no effect. The Fed believes that this strategy worked to improve the economy (Gagnon, Raskin, Remache & Sack, 2010).

The final monetary policy tool that the Federal Reserve uses is the reserve requirements. Like open market operations, these affect the amount of money in the economy, by changing the amount of money in the banking system. The way it works is this. Every bank takes in deposits so that they have capital to lend out. In order to preserve the integrity of the banking system, the banks cannot lend out all of the deposits they take in. The amount that they are not allowed to lend out is known as the reserve requirement. The Federal Reserve has the capability of changing the reserve requirements. If the Fed tightens the reserve requirements, this will take money out of the economy, because banks will need to reduce the amount of money that they are lending out; conversely if the Fed loosens the reserve requirements, this will put money into the economy because banks will be allowed to lend out more of their deposits out.

Changing the reserve requirements is an inelegant solution, so it is not used much. The process by which the banks will call in loans, or stop lending outright, can have a significant negative effect on particular individuals and businesses that simply have the misfortune of seeking a loan right after the change in Fed policy. Furthermore, the banks cannot execute a change in reserve requirements very quickly, and this time lag is a little bit more clumsy than other major monetary policy instruments, which work more quickly.

Objectives of the Federal Reserve

As noted, the Federal Reserve has objectives balancing inflation, unemployment and moderate long-term interest rates. In some cases, the Fed will state its objectives explicitly but sometimes these objectives are outlined in more vague terms. Often this relates to the degree to which the markets need specificity from the Fed. The Federal Reserve publishes a "Statement on longer-run goals and monetary public strategy" which outlines its objectives. In the most recent version of this document, the Federal Open Market Committee outlines its objectives. They note that the interest rate can be influenced heavily by the Federal Reserve, in particular using the discount rate. Given this, the Fed typically will focus on the discount rate as a powerful tool for implementing monetary policy.

The inflation rate is adjusted by the Fed to be the personal consumption expenditures index. The Fed has settled a target of 2% as the optimal inflation rate, the most consistent with the Fed's mandate of long-run price stability, combined with a mandate to manage unemployment and therefore promote economic growth. The Fed that believes confirming this target rate is critical to managing market expectations of Fed action, because it believes there is information asymmetry between the Fed and the market, where Fed announces signal to the market the nature of the private information (Romer & Romer, 1996). This level should have been developed using empirical studies. Given the target and the power of the discount rate, the Fed has a high degree of control over the interest rates. The Fed has less control over the interest rate than it does over interest rates, but there is a fairly predictable relationship between interest rates and the inflation rate.

Under normal circumstances, lower interest rates will spur economic growth. Robust economic growth in turn spurs inflation as certain parts of the economy begin to face the condition of scarcity, which occurs when the growth in the economy brings the demand for a good to a point higher than the supply of the good. Open market operations also influence the inflation rate by influencing the desire of businesses and consumers to invest, which would again increase demand. In both… [END OF PREVIEW]

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