The Federal Reserve System has been the central bank of the United States since 1913 and since its formation; the bank provides flexible, safer, stable financial and monetary system. Presently, the major duties of the Federal Reserve is to influence the monetary and credit conditions in the economy to pursue stable price, maximum employment, and moderate long-term interest rates. Open market operations, the reserve requirements and the discount rate are the monetary tools that the Federal Reserve uses to implement monetary policy. Federal Reserve uses these three tools to influence the supply and demand of balances in depository institutions and thereby alter the interest rates. However, changes in the federal funds rate could trigger a chain of events and affect economic variables such as:
short-term interest rates
Foreign exchange rates
Long-term interest rates
Amount of credit and money in the system,
Inflation (Increase in prices of goods and services), and Investment.
Objective of this essay is to discuss how a change in the monetary policy triggers chain of reactions stipulated above.
Effects of Change in Monetary Policy
"The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals." (Federal Open Market Committee, 2011 P1). Federal Reserve Act spells the goal of monetary policy and specifying that the Federal Open Market Committee and the Board of Governor should promote stable prices, maximum employment as well as moderate interest rate. Open market operation is one of the monetary tools that the Federal Reserve uses in carrying out the monetary policy and open market operation is the purchase and sell of security in order to control the funds in the economy. When there is inflation in the economy, the Federal Reserve will sale the Federal notes to the financial market to withdraw money in the circulation to curb the inflation rate and high interest rates. (Blanchard, Giovanni, and Paolo, 2010). On the other hand, Federal Reserve could use open market operation to boost investment to create more employment opportunity. The strategy is by buying up the credit notes in the financial markets. However, changes in monetary policies through open market operations, reserve requirements and contractual clearing balances could trigger chain of event in the economy.
Essentially, modern financial system is interdependent and complex and may be vulnerable to large-scale systemic economic disruption. Announcement by Federal Reserve that it would increase federal funds rate will immediately trigger the increase of short-term interest rates and long-term interest rates, stock prices and the foreign exchange value of the dollar. Changes in these variables will ultimately affect business and household spending decision thereby affecting the aggregate demand and the whole economy.
Economic news and statements by officials will have greater effect on the short-term interest rates, and changes in short-term interest rates will affect long-term interest rates such as corporate bonds, Treasury notes, fixed-rate mortgages, auto loan and other commercial loans. Moreover, change in the long-term interest rates will have effect on the stock price, which can ultimately affect the household wealth. Investors generally keep their investment returns on stocks and bonds. If there is a decline in long-term interest rates, there would be a decline in the return on bonds and increase of return on stocks thereby encourage investors to purchase stocks and discourage investors to purchase bonds. The decline in the interest rates will convince investor that profits will be higher and economy will be stronger in the future thereby encourage investment opportunity in the country, increase the aggregate demand and employment opportunities. (Illustration is presented in Fig 5).
Changes in monetary policy also affect the exchange rates of U.S. dollars on currency market. Rise of the interest rates in the United States will make the returns of dollar assets become favorable leading to the high bidding of dollars in the foreign exchange markets. Typically, the increase in dollar value will decline the costs of imports to U.S. residents and raise the price of U.S. exports. Conversely, lower interest rates will decline the exchange value of dollar leading to a decline in the price of export and increase in the price of import.
The change in the monetary policy can also affect the investment opportunity within the country. Typically, monetary policy influences the value of financial assets, which ultimately influences a wide range of spending decisions. For example, a lower exchange value of the dollar, a decline in interest rates and higher stock prices will consequently stimulate various types of spending. The investment will become more attractive because of the lower financing costs. Typically, higher stock prices will increase household wealth, which consequently increase the purchasing powers of average Americans. A drop in the interest rates will boost U.S. export by lowering services in foreign markets and costs of goods. A drop in interest rates will also make imported goods and services more expensive than goods manufactured in then country, which will make the U.S. households and businesses to purchase goods and services domestically produced. All these effects will strengthen the growth of aggregate demand. (Blinder, 2000) Moreover, lower interest rates on consumer loan will influence greater demand for consumer goods. Lower mortgage rates will lead to more housing purchase because the housing will be more affordable, and this will reduce ongoing housing costs, encourage mortgage refinancing and enable households to purchase other goods and services. On the other hand, when the Federal Reserve tightening monetary policy, the reverse will occur. The illustration with the graphs below further explains how changes in the monetary policy trigger chain of effect in the economy.
Illustration with Graphs
The paper uses graphs to illustrate restrictive and expansionary monetary policies to enhance greater understanding on how monetary policy triggers chain of effect in the economy. The illustration in Fig 1 reveals the demand for money, and money demand is downward slope. However, money supply curve is a vertical line since the Federal Reserve Board is controlling domestic money supply. The interest rates are labeled ro and the equilibrium of interest rates are being influenced by the interaction of demand and supply of money.
However, the graph in Fig 2 shows the restrictive monetary policy leading to the reduction of money supply in the economy. The money supply will shift from the right to the left from Mo to M, and decrease in the money supply will increase the interest rates. In 1994, the Federal Reserve used the open market operation to reduce the money supply from Mso to Ms1, and the decline in money supply increase the market interest rates from ro to r1.
The graph in Fig 3 reveals the relationship between interest rates and investment. With increase in interest rate, there will be a decline in investment because it will be expensive for firms to borrow money, which will lead to a decline in the investments opportunity. The increase in interest rate from r0 to r1declines investment from lo to l1
Essentially, investment is a major component of aggregate demand and GDP. Thus, a decrease investment due to high interest rates will lead to a decline in aggregate demand, and decrease in aggregate demand will reduce the total output. However, this will decrease the inflation rate. Conversely, decrease in interest rate will increase the investment opportunity because it will become less expensive to borrow money from the bank. The decline in the interest rate will increase incentive to borrow leading to the increase in investment in new capital. Moreover, decrease in interest rates increase the aggregate demand and thereby increase the inflation rates.
Conversely, expansionary monetary policy increases the interest rates because of the increase in the money supply. As being revealed in fig 4, the increase in interest rates will…