Federal Reserve the Current State of the Essay

  • Length: 7 pages
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  • Subject: Economics
  • Type: Essay
  • Paper: #90938431

Excerpt from Essay :

Federal Reserve

The current state of the United States economy is not encouraging. Even though there has been false hope about it, the chances are that it will hardly last for long. The long-term trends that are negatively impacting the economy and financial system are showing no signs of reducing. As each day passes, the economic foundations of the country continue to crumble. The debt of the country has increased and the population is consuming more wealth than what is produced. In addition, unemployment and inflation levels are high coupled with slow economic growth, which remain the main features of the U.S. economy. The Federal Reserve is the key to solving the current economic situation that is experienced in the U.S. This is because it is the central bank of the United States and the operations of every bank are monitored by the Federal Reserve (Hafer, 2005). In 1913, the Congress passed legislation to allow Federal Reserve to control the economy, through providing investors with haven for their money. The system is considered to be a flexible, and stable financial and monetary system.

Over the past decade, the roles of Federal Reserve in both the economy and banking sector have expanded. Currently, the Federal Reserve undertakes the U.S. monetary policy through influencing credit and monetary conditions in the economy with an attempt of pursuing stable prices, maximizing employment and stabilizing interest rates in the long run. In addition, it regulates and supervises all the banking organization in order to preserve the U.S. financial and banking system from fraudulent activities that have been rampant in the economy. As such, the consumer's credit rights are protected from exploitation by banking institutions. Consequently, Federal Reserve ensures that stability is maintained throughout the financial and monetary system, and systemic risks, commonly felt in the economy, are contained. Finally, Federal Reserve System ensures that reservoir institutions are provided with regular and consistent financial services. Apart from depository institutions being channeled with financial services, foreign financial institutions and U.S. government also depend on Federal Reserve to provide them with financial services.

Though the key role of Federal Reserve is to influence price levels and quantity of output required in the economy, it also contributes to betterment of economic performance and financial stability (Meltzer, 2010). This is achieved through containing any financial upheavals and prevention of its spread in the economy. The current financial systems have become interdependent and complex and pose a threat to systemic disruptions, for instance, stock prices plunging. However, Federal Reserve can enhance the resilience of the financial system in order to mitigate these shocks. This will be achieved through imposing regulatory policies on payment systems and banking institutions. As such, in the case where there is the development of a threatening disturbance, the Federal Reserve ensures that the impact in the economy and financial markets are cushioned through visibly and aggressively provided liquid cash by way of discount window lending or open market operations (Hafer, 2005).

Federal Reserve relies extensively on economic indicators in an attempt to ascertain the health status of the economy. The economic indicators that it can use in analyzing the current state of the economy include Consumer price index (CPI), unemployment rate, or gross domestic product (GDP). The main policy making body, the Federal Open Market Committee (FOMC), has been entitled with the responsibilities of examining economic indicators in order to ascertain the correct monetary policy to be imposed. The Federal Reserve uses the GDP report to gauge economic activity. Investors look for signs of sustainable economic growth in the GDP report, paying especially close attention to the information it contains on corporate profits. Ideally, GDP is the monetary value for all goods and services produced in a nation during a given time period, usually one year (Mullins, 2009).

The other economic indicator can be used by Federal Reserve is the consumer price index. Ideally, Federal Reserve uses CPI to determine the weighted average of prices for a given quantity of goods and services. The analysis enabled the Federal Reserve to determine the periods that experience inflation or deflation. When it determines the inflationary or deflationary trend of the economy, the Federal Reserve would initiate both fiscal and monetary measures to safeguard the economy against adversity of the conditions. Finally, unemployment rate indicates the stability of the economy. In the case where unemployment rate is high, the Federal Reserve will initiate measures, either through reduction of tax rates or increasing the money supply, in an attempt to reduce the level of unemployment in the economy. Unemployment rate hampers economic development and growth, and if not sustained, its effects will be felt for many years.

There are various ways in which the Federal Reserve can use the monetary policies in influencing money supply in the economy. Open market operations are considered the most preferred policy tool by the Federal Reserve in controlling money supply in the economy. This policy tool involves trading of government securities such as Treasury bills, Notes and Bonds in the open market. To increase money supply in the economy, the Federal Reserve buys the securities and by purchasing them, large amounts of cash are injected into the economy (Mullins, 2009). On the other hand, to decrease money supply in the economy, the Federal Reserve sells large amounts of these securities and the resulting effect is the reduction of money in circulation.

The second method that can be used to influence money supply is altering the reserve requirements for banks. It is mandatory for banks to maintain a certain percentage of deposits from their client for the purpose of facilitating systematic withdrawals. To decrease money supply in the economy, the Federal Reserve increases the level of the reserve requirements for the banks. This has the effect of reducing the amount of money in circulation thus, pushing up the interest rates. Otherwise, to increase money supply, the Federal Reserve lowers the reserve requirements for banks leading to lots of money in circulation, thus reducing the interest rates.

The third method is the alteration in the discounting rate, which refers to the charges by Federal Reserve on banks borrowing from it. These take the form of short-term loans that are taken overnight for the purpose of covering deficits that occur in the reserve requirements (Mullins, 2009). It is the responsibility of the Federal Reserve, but not the market forces of demand and supply that set this rate. Banks normally borrow money from each other to increase their reserves, and only borrow directly from the Federal Reserve when they have no option.

The U.S. Federal Reserve uses the monetary policy in regulating money supply in the economy with the objective of promoting economic growth and holding inflation to a lower level. One of the strengths of the monetary policy is that it stabilizes prices of commodities in the economy. Inflation has the impact of harming the value of money in that it reduces its purchasing power. The rise in inflation at a faster rate makes the Federal Reserve to dispose of the government securities or increase short-term interest rates in order to reduce money in circulation (Hafer, 2005). The impact of these actions is that it causes lending institutions such as banks to increase long-term interest rates. This consequently, reduces accessibility of credit and consumer spending thus, curbing inflation rise in the economy.

The second strength of the monetary policy is that this tool can be used immediately in producing quick results. It is not affected by time lags from the Congress, which has to hold sittings to approve any government spending as in the fiscal policy. If inflation rises, The Fed would immediately initiate monetary policy mechanism to counter it, leading to economic stability with a very short time (Axilrod, 2009). The third strength about the monetary policy is that it has no political inclination like fiscal policy, which has to get support from a given party to go through. The monetary policy works for the interest of the economy of the United States unlike fiscal policy, which serves the interests of few people in the politics.

Even though monetary policy is a good tool in influencing money supply in the economy, it has some drawbacks. One of the weaknesses associated with the monetary policy is that it works effectively only on tight money policy, but not on loose money policy. Tight money policy has the effect of reducing money in circulation. On the other hand, the loose money policy for it work effectively, people have to create the need for loans as well as the need for spending money. The second weakness of the monetary policy is the monetary velocity. Money supply does not depend on the number of times in a year that a dollar trades with goods and services. This can give rise to contradictions as the Federal Reserve works to stabilize the economy. In addition, a conflict exists between sustainable economic growth and low inflation resulting from their objectives. There is existence of trade-off…

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