Federal Reserve and Economy

Federal Reserve works with three main policy tools -- reserve requirements, the discount rate and open market operations (St. Louis Fed, 2017). Each of the three has its strengths and limitations. They influence the amount of economic activity in different ways, which makes each one slightly different in how frequently it is used.

The discount rate is setting the rate at which banks can borrow money, which basically sets the baseline cost of money in the economy. The discount rate is used frequently because it is relatively easy to adjust, and has an immediate impact on the cost of money throughout the economy. In addition, the Federal Reserve will often telegraph its interest rate moves, as a means of influencing the economy even before the move occurs, so that the change ends up being more gradual than it otherwise would have been. The discount rate, because it affects the price of money, works by influencing the demand for money -- the more costly that money is, the fewer people will want to borrow.

Reserve requirements are the percentage of funds that banks need to hold back in reserve. By adjusting these, the Federal Reserve is directly influencing the amount of money that is released into the economy. This is a seldom-used tool, with good reason. Essentially, if reserve requirements are loosened, this increases the supply of money in the economy, which should lower its price. But it does not necessarily increase demand. The bigger issue, however, comes if reserve requirements need to be tightened. Such an action could trigger banks to call in loans prematurely in order to boost their reserves. That would have a substantial cooling effect on the economy, and it would be shocking. Businesses could be put into bankruptcy if forced to pay back their loans ahead of schedule. So the real risk with using reserve requirements to influence the money supply comes if they ever need to be tightened.

The third tool are the open market operations. These are the most frequently used. They directly influence the quantity of money in the economy. The Federal Reserve buys or sells Treasury Bonds, so when it buys it puts money into the economy and when it sells it takes money out of the economy. The Federal Reserve can do this on a daily basis. It can buy and sell bonds with different terms, too, and has become more active in conducting open market operations with longer-term bonds in recent years. This tool is the easiest to do, it does not create economic shocks, and it can be more refined in terms of the quantities and timing, which means that the bank can execute its influence much more easily using this particular tool.

2a) The scenario described has the following conditions. Unemployment is higher than where the Fed would probably like it to be, though in this fictitious scenario we don't know the trend. But if consumer confidence is also low, then the economy seems to be in need of some stimulus. Inflation is relatively low, which reflects a condition where the economy is not overheated. An inflation rate of 1.5% is actually below the rate that the Fed typically targets.

Keynesian fiscal policy theory holds that national economic output is reflective of both consumer and business trade, government spending and the trade balance. If consumer confidence is low, then that is an area that could be addressed, and lowering the unemployment rate can contribute to that. Increasing government spending in such a situation would help to create more employment, and stabilize the economy. The objective would be to get to a point where consumer confidence increases enough to bring about some spending increases, which would allow businesses to think more about investing. But under Keynesian theory this starts with fiscal policy that emphasizes government spending that emphasizes job creation.