Monetary Policy Fed Monetary Policy

Monetary Policy

Fed

Monetary policy and the Federal Reserve System

"Money makes the world go 'round." If this cliche is true, then the obvious question is: what is money? Despite all of the power we accord to it in our society, money is really merely a placeholder of value, a kind of philosophical idea, rather than an object of value. It is "a medium of exchange that is widely accepted in payment for goods and services and in settlement of debts…Without money, trade would be reduced to barter or the direct exchange of one commodity for another" commodity (Kliewer 1997). The Federal Reserve Bank in the United States is currently headed by Fed Chairman Ben Bernanke, who sets monetary policy for the entire nation. For example, Bernanke is responsible for determining the interest rate and the discount rate, as well as influencing the amount of money circulating in the economy. One way of thinking of the Fed is that it is "it is the bank of banks and the bank of the U.S. government" (Obringer 2009, p.1).

"Before the Federal Reserve was created in 1913, there were over 30,000 different currencies floating around in the United States. Currency could be issued by almost anyone -- even drug stores issued their own notes. There were many problems that stemmed from this, including the fact that some currencies were worth more than others. Some currencies were backed by silver or gold, and others by government bonds" (Obringer 2009, p.2). This shows the arbitrary nature of money -- unless it is controlled by a central bank. Obviously, this is no longer the case. Instead, to either stimulate the economy during a recessionary period or curtail inflation, the Fed uses various tools at its disposal to improve the economy as a whole. The Fed's primary duties are to create "liquidity," to make sure banks can honor their customer's need for money with hard currency, to control inflation (that is, to prevent people or other institutions from printing money at will) to make sure prices don't climb too quickly, and to increase or decrease the country's supply of available funds in order to prevent inflation and recession (Obringer 2009, p.1).

One of the most obvious tools from the consumer's point-of-view that the Fed possesses is the interest rate. When a recession seems immanent, the Fed lowers interest rates to make it easier for consumers to borrow money from banks and use other credit sources. As the 'bank's bank,' the Fed lowers the discount rate or the rate of borrowing it charges member banks. This means that banks can more easily borrow money from the Fed to meet their reserve requirements, or the amount of liquid assets they must keep to meet consumer demand. The Fed, to stimulate the economy, can also lower bank's reserve requirements, meaning the banks need to keep less available assets on hand. When the economy is expanding too quickly, and recession is a risk, the Fed can reduce the amount of currency circulating in the economy by raising interest rates, raising the discount rate, and raising reserve requirements, and also by selling government securities.

When interest rates are low, people have a greater incentive to borrow and to spend money. That new car or home they have been 'putting off,' seems much more attractive when the interest rate is nearly zero! But perhaps "the most effective tool the Fed has, and the one it uses most often, is the buying and selling of government securities in its open market operations. Government securities include treasury bonds, notes, and bills. The Fed buys securities when it wants to increase the flow of money and credit, and sells securities when it wants to reduce the flow" (Obringer 2009, p.10).

Given the magnitude of the current economic crisis, the Fed has been taking aggressive actions with the specific aim of stimulating consumer spending, and hopefully production and employment to meet increased demand as a result: "The target fed funds rate will be below .25%…effectively at zero. The Fed is going to the 'zero bound' (i.e., a nominal rate of 0%, below which a lender has to pay a borrower to take the money, which is unlikely to continue for long). Monetary policy has been effectively at zero for some time. It will be 0-.25% until probably 2010" (Tepper 2008). In a less publicized, but still critical action, the Fed has been purchasing private securities to inject funds into the economy" (Tepper 2008). Because the Fed "expects a long and deep recession" it therefore plans on long-term policy commitment to low rates" for both consumers and banks (Tepper 2008).