Federal Reserve in stabilizing the economy using monetary policy tools. The paper is divided into six major sections. The first section introduces the Federal Reserve by highlighting its objectives, roles, and composition. The second section explains its role and effectiveness in stabilizing the current U.S. economy. The next section discusses some important economic indicators which the Federal Reserve can analyze for better economic stabilization. The fourth section is dedicated for a brief discussion on different monetary policies which the Federal Reserve can use to influence the money supply in the country. The final two sections explain the strengths and weaknesses of monetary policy as compared to fiscal policy and its effect on the aggregate demand and supply model.
Introduction: The Federal Reserve
The Federal Reserve System is the central bank of the United States of America. It is also called as Federal Reserve or simply as Fed. It is the prime regulatory authority for the commercial banking and financial sector of the country. Headquartered in Washington, D.C, Federal Reserve was established in 1913 under the Federal Reserve Act. The Fed is headed by the Chairman of the Board of Governors. He is the supreme authority who has the power to control and finalize the decisions recommended by the Board. The Board of Governors (commonly called as the Federal Reserve Board) constitutes 7 experienced and highly competent and qualified individuals who have vast exposure in the banking, commercial, and financial sector (Federal Reserve, 2013).
The Federal Reserve Board is the sole policy making authority for the commercial banking and financial system of the country. The Federal Reserve System also consists of 37 Federal Reserve Banks which are spread across the States and perform their functions on behalf of the Fed. In addition, there are two important bodies of the Federal Reserve System; called as Federal Open Market Committee and the Federal Advisory Council. These bodies perform open market operations and advisory role for the Fed respectively (Federal Reserve, 2013).
The Role and Effectiveness of the Federal Reserve in Stabilizing the Current Economy
i. Control of Inflationary Pressures:
As the central bank of the United States, the Federal Reserve performs a variety of functions to reform, develop, stabilize, and strengthen the country's economy. The most important role of the Fed is to control the inflationary pressures on the economy which arise due to the price inelasticity. Inflation negatively impacts the growth of industries, commercial sectors, household purchasing power, and the overall economic development. Fed makes every effort to keep the country's inflation rate in check so as to help the important participants of the economy to grow at a steady pace. It uses different policies, tools, and strategies to control the inflation and eliminate its negative impacts from the economy. For example, it sets the official interest rate for the United States in order to control the inflationary pressures as well as stabilize the exchange rate.
ii. Supervision of Banking and Financial System:
Secondly, the Federal Reserve supervises the activities and functions of the commercial banks and financial institutions in the country. It ensures that commercial banks and FIs operate under the strict regulatory guidelines and business ethics. In order to stabilize the U.S. Economy after the recent financial crisis, the Federal Reserve implemented more strict prudential regulations for the commercial banks and financial institutions. For example, it tightened the lending capacities of banks; especially in the housing finance, mortgage, and consumer banking facilities so as to restrict them from lending to those people who do not have sufficient repaying abilities.
iii. Agent of the Government:
The Federal Reserve also performs as an agent of the U.S. Government in numerous areas. For example, setting fiscal policy measures; defining priority sectors for the allocation of the national resources; planning and analyzing the potential investment areas; and promoting research and development in the under-privileged areas of the country. Due to its agency function for the U.S. Government, the Federal Reserve is also called as the 'Government's Bank'.
Revival after Financial Crisis:
The Federal Reserve played an active role in the reformation process of the banking sector after the most recent Financial Crisis which badly hit the U.S. Economy as well as the whole financial sector in the world in late 2007. The Federal Reserve revised its prudential regulations and other policies to ensure that the banking and financial system of the country performs in the most transparent and efficient way (Federal Reserve, 2013).
Economic Indicators to be analyzed by the Federal Reserve for better Economic Stabilization
There are various economic indicators which can be used to see the performance of an economy during a particular period of time. These economic indicators are used by the central bank, industrialists, commercial banks, business corporations, and foreign investors, and the government of a country. Each economic indicator measures the state of one particular area of the economy. Therefore, the Federal Reserve uses only a few important economic indicators to analyze the current state of different sectors in the U.S. (Federal Reserve, 2013).
Inflation and Consumer Price Index (CPI):
The most important economic indicator for the Federal Reserve is the rate of inflation in the country. Inflation is generally considered bad for a country's economic development due to its negative impacts on each participant of the economy; including households or individuals, business corporations, and the government. The Federal Reserve analyzes the rate of inflation through Consumer Price Index (CPI) which measures the change in the retail prices of the consumer goods over time. Consumer Price Index (CPI) is directly related to the purchasing power of the general consumers. Therefore, the Federal Reserve uses it to analyze whether the economy is running with excess or otherwise short supply of money (Federal Reserve, 2013).
Balance of Payment (BOP):
Balance of Payment (BOP) measures the amounts received from abroad against the payments made to abroad. It is basically related to the foreign trade operations, transfer payments, trade balances, and the difference between exports and imports. If the United States receives greater amount as payments from abroad as compared to its payment going to abroad, the balance of payment is positive. In contrast, if the payments from abroad are less than payments made to abroad, the U.S. is said to be running a negative balance of trade. The Federal Reserve uses this important economic indicator to analyze the U.S. economy more deeply. As balance of payments is directly related to the national currency, the Federal Reserve makes efforts to bring it to towards positive side so as to make the U.S. Dollar an attractive currency for the World trade. This is done by putting ban on unnecessary imports, international fund transfers, and other import restrictions.
Interest rates directly impact the price of U.S. Dollar in the foreign exchange market. In order to revive the banking and financial sector of the country from the most recent financial crisis, the Federal Reserve lowered the short-term interest rates and brought them to nearer to zero. Similarly, it lowered the long-term interest rates by purchasing long-term treasury securities. With the low interest rates, the individuals and business corporations found more room for investments, loan facilities, and rehabilitation after they were hit by the financial crunch.
Monetary Policies to Influence the Money Supply
Monetary policy is the process by which the Federal Reserve influences the money supply in the U.S. Economy. The basic purpose of implementing monetary policy is to stabilize the prices of goods, achieve economic growth, and minimize the level of unemployment in the country. The Federal Reserve uses monetary policy to change the interest rates and the money supply in the U.S. (Federal Reserve, 2013).
Monetary Policy Tools:
Monetary policy can be changed by the Federal Reserve in a number of ways. These are generally called as monetary policy tools. In order to influence the money supply in the country, the Federal Reserve uses monetary base as an important monetary policy tool. In order words, monetary base is considered as a primary tool to increase or decrease the money supply in the country. Monetary base is carried out through Open Market Operations which influence the short-term interest rates and the U.S. currency circulating in the country (Federal Reserve, 2013).
Open Market Operations:
Open market operations indirectly influence the total money supply in the United States. In these operations, the Federal Reserve purchases the governmental securities, bonds, and other financial instruments to influence in the money supply. By purchasing these instruments, the Federal Reserve basically throws out more money in the open market which increases the money supply in the country. The Federal Reserve performs this activity when it has to increase the level of inflation in the country. Converse to this policy, the Federal Reserve can sell governmental securities and financial instruments when it has to control the inflationary pressures in the country. Both these types of open market operations impact the money supply with the commercial banks in the country.