Monetary policy frameworks and economic effects

Monetary Policy

Every economic activity in the United States is related to the policies that are decided by the monetary policies of the nation that are formulated. This involves all activities like purchase of houses, starting up of new business enterprises, and expansion of businesses, investments in new plants or machinery. It also affects our investment decisions like putting our investments in banks, bonds, or the stock market. It is also well-known that the United States is the biggest economy of the world, and this causes its economy to have affects on them, and thus any decision about the monetary policy of the United States will also have an effect on them. The purpose of any monetary policy in any country is to correct the then present shortcomings of the economy like the situations of inflation or deflation, economic output and finally the most important of them all - employment.

Monetary policy is the segment of the Federal Reserve System, a unique U.S. agency. They are the central bankers for the country and supplies the presently "gold less" money that is supplied by the government printing presses. The methods used for increasing and decreasing the demand for money is through the increase and decrease of short-term interest rates, in reverse order. 2 "The Fed," as it is usually called, is comprehensive of 12 regional Federal Reserve Banks and 25 Federal Reserve Bank branches. All nationally recognized commercial bank are in demand by the law to be members of the Federal Reserve System, membership is of choice for state recognized banks. 3

1. "U.S. Monetary Policy: An Introduction" Available at http://www.frbsf.org/publications/federalreserve/monetary/Internet; Accessed 09 December, 2003

2. "U.S. Monetary Policy: An Introduction"

3. "The Goals of U.S. Monetary Policy" FRBSF Economic Letter, 99-04; January 29, 1999 Available at http://www.frbsf.org/econrsrch/wklyltr/wklyltr99/el99-04.html. Internet; Accessed 09 December, 2003

The Federal Reserve Board of Governors rules the Federal Reserve System. The Fed then constitutes of two main legislated aims for monetary policy: inculcating full hiring and enhancing stable prices. With this rule, the Fed has given a hand in promoting the unique performance of the U.S. economy at the time of the past ten years. Still, some have made a debate that the Fed's rule could be enhanced, particularly in foreseeing future efforts to manipulate or reinstate current low inflation. 4

Much debate has encompassed the two topics: the clarity of the goals and their two-sided feature of the U.S. monetary policy. The clarity of aims pinpoints to the level to which the aims of monetary policy are clearly elucidated and can be conveniently and transparently realized by the public. The aim of full fledged hiring will never be clarified due to the fact that it is not directly monitored but only foreseen by economists with constrained accuracy. For instance, the 1997 Economic Report of the President provides an array of 5 to 6% for the unemployment proportion in continuance with full employment, with an average of 5.5%. Research gives suggestion that there is a prevalently high array of indecisiveness around any estimate of the natural proportion, with one significant analysis discovering a 95% probability that it comes under the wide array of 4 to 7 1/2%. 5

4. "The Goals of U.S. Monetary Policy" FRBSF Economic Letter, 99-04; January 29, 1999 Available at http://www.frbsf.org/econrsrch/wklyltr/wklyltr99/el99-04.html. Internet; Accessed 09 December, 2003

5. "The Goals of U.S. Monetary Policy"

Price stability as an aim is also prevalently under some uncertainty. Current economic study has envisaged systematic partiality, say, on the array of 1 percentage point, in the CPI's proportion of inflation. In this probability, actual price stability would be continued with proportionate inflation of 1%. Adding up to this, at any juncture, variant price indexes record variant proportions of inflation. In the passage of the year, for instance, the CPI has peaked at about 1-1 1/2%, while the GDP price index has peaked at about 1%. Still, an obvious price stability aim could be mentioned as a concise numerical growth proportion (or array) for a significant index which could consider any partialities. Anyhow, economists have come up with the suggestion of other means to grow the clarity of policy. For instance, releasing medium term inflation predictions might give a hand in elucidating the direction of policy according to Rudebusch and Walsh. 6

Due to the fact that the central bank has some manipulation over inflation in the average term, its predictions would be consistent of signs of where it required the inflation to direct to. A second current suggested updating to the Fed's goals is involving pinpointing to a larger array on price stability and under stressing business cycle stabilization. Some economists have debated that having multiple aims will give rise to inflation partiality in spite of the Fed's standard efforts to manipulate inflation. This debate emphasizes that the eagerness to manipulate gains in result in the short duration will override the central bank's anticipation to manipulate inflation in the longer course of time.

6. "The Goals of U.S. Monetary Policy" FRBSF Economic Letter, 99-04; January 29, 1999 Available at http://www.frbsf.org/econrsrch/wklyltr/wklyltr99/el99-04.html. Internet; Accessed 09 December, 2003

Resultantly out of increased inflation anticipations of the general public, inflation will terminate being greater than the central bank proposed, in spite of its standard attempts. This inconsistency in period debate, as economists term it, multiplied with the suffering met in the 1970s as inflation shot up and in the preliminary 1980s as inflation was mitigated to moderate phases, was persuasive that many of the chief aim of the central bank should be to moderate costs. 7

The Federal Reserve monetary policy has always tended to concentrate on the internal economy. Even though the factors of international importance have not been totally been rejected, they have always been given less importance when compared to the national factors. The trends which are occurring in the recent days suggests that the monetary policy of U.S. cannot be completely detached or even given less consideration than the national concerns. 8 The decisions on monetary policy are made by the Federal Open Market Committee. This is a committee made up of the governors of the Federal Reserve System and the presidents of the Reserve Bank. The general objective for the increase and decrease of the interests is an indirect method for the reduction or increase of demand, and through demand, supply.

7. "The Goals of U.S. Monetary Policy" FRBSF Economic Letter, 99-04; January 29, 1999 Available at http://www.frbsf.org/econrsrch/wklyltr/wklyltr99/el99-04.html. Internet; Accessed 09 December, 2003

8. Sazton, Jin.International Dimensions to U.S. Monetary Policy, Joint Economic Committee Study, August 2000 Available at http://www.house.gov/jec/fed/intern.htm. Internet; Accessed 09 December, 2003

It should also be noted that the real interest rates as available for money in the market is only applicable to the producers of goods and services and not the rates given in the bulletins. The other impact on interest rates is the impact of inflation, and this must be reduced from the nominal rates that the manufacturer or supplier of service is paying. He is repaying the loan after some period, normally in years, and at that time, the same amount will have a decreased value due to the inflation. This makes the impact of inflation have very high effect on the real interest rates and through that on the monetary policy. Sometimes a situation will also be available when the value of storing money will become negative, unlike the old concept of silver dollars.9 situation like this occurred in 1978 when the average interest rates for money were around 8% but the rate of inflation was around 9%. This meant that money was being given at an annual discount of 1% by the monetary authorities. The people who had stored their savings were at the same time losing at that rate on the money they had stored with the banking authorities. It may be said to be a situation where "Peter was being robbed to pay Paul." Luckily this sort of situation did not go on for very long in the United States. In 1999, the interest had come to around 4.75% and the inflation rate was around 2%. In effect, the interest of 8% was cheaper for the borrower than 8%. At the lower figure, the inflation made sure that he had to pay some interest when he borrowed money. 10

9. "How does monetary policy affect the economy?" Available at http://www.frbsf.org/publications/federalreserve/monetary/affect.html. Internet; Accessed 09 December, 2003

10. "How does monetary policy affect the economy?"

The changes in the real interest and by that one means not the advertised interest rates, but the interest rates after the consideration of the impact of inflation, affect the public's demand for the goods and services. This has an impact on the cost for borrowing for any purpose, reduces or increases the availability of loans from banks, the savings of individuals and even foreign exchange rates. Of these the last named is often determined directly by the government and is not freely transferable in the case of many countries. Theoretically, decreased cost of real interest should lead to increased business investments and household purchases of durable goods. The type of goods that one is talking about is automobiles and new homes here. This is expected to increase the spending by individuals who may be totally depending on the banks for their money. This has however to be combined with a positive outlook for the economy which will give the borrower the confidence of his being able to repay the loan. As we have already seen, when the real interests are negative, the inflation rates are high, and that is a negative sign for the economy. The people also realize that costs are increasing and they may not have enough confidence in themselves to beat the inflation rates. In which case, they may not go in for the loans and thus defeat the purpose of the lower interest rates. 11

Theoretically this is also a period when the shares and other similar investments look attractive as compared to bonds and other instruments for debt. This will have a result for people who find that the value of their shares have gone up and thus may be tempted to invest more in shares. When such investments take place, it will also provide funds for the industries to go in for new plant and machinery as the interest rates for such investment will be low. Then can also issue stock at high prices to pay for the costs of their new plant and machinery.

11. "How does monetary policy affect the economy?" Available at http://www.frbsf.org/publications/federalreserve/monetary/affect.html. Internet; Accessed 09 December, 2003

Once the price of the dollar is reduced, it will also make the other foreign currencies available at a higher rate against the dollar. This will increase the prices of goods produced in those countries in the United States. This will reduce the demand for hose goods, and increase the exports from the United States as they will receive the goods from the United States at cheaper rates. This will raise the demand for such goods and in turn the factories concerned will have to produce more. This will in turn lead to demand for plant and machinery from them. This will again lead to increases in production and employment. This again will lead to another round for demand. This is a cycle that gives unending opportunities for growth. 12.

There are of course a lot of theories as to how the wages and prices are expected to rise faster through the stimulus of monetary policy. This is expected to push the labor and the capital markets beyond even the capacities they are planned to have. This is true only in the short-term and in the long run may have quite different results. It is said that a regular effort to keep costs at low levels continuously will end up in high inflation rates for the country and also high nominal rates of interest. The increase in output that may be seen in the short-term will not last for very long periods and the decreases in unemployment will also not be permanent. The efforts made by one country to inject vitality in their own system at the cost of others will be countered by them. Thus the effects of any monetary policy changes are at best short-term. The questions of output and employment cannot be decided by changes in monetary policy. 13

12. "How does monetary policy affect the economy?" Available at http://www.frbsf.org/publications/federalreserve/monetary/affect.html. Internet; Accessed 09 December, 2003

13. "How does monetary policy affect the economy?"

Thus we see that monetary policy agrees that it is possible to lower unemployment for a relatively small period by agreeing to suffer from the effects of high inflation, but at the end, the figures for the country will return to normal and the benefits will disappear. These changes when implemented regularly will also force people to think about the possibilities of inflation in the later times. When the Federal Reserve Board will make money availability easier, the people will know that in the end it will cause inflation. This will make the concerned people try for wage and price increases to counter the effects of inflation. This is in itself a major reason for inflation and will not really have any impact in terms of employment and output. Today the world is very well linked and any effect in one country is rapidly carried over to another country and the inflation may not be dependent only on the capacities within the country, but is related to the capacities in the entire world. 14