United States Federal Reserve System: The Federal

United States Federal Reserve System:

The Federal Reserve System or the Fed was established by President Wilson in December 1913 to promote the development of a stable, flexible, and safer financial system in the country. President Wilson enacted the Federal Reserve Act, which was a conclusion of the findings of a commission that was mandated with the task of examining the 1907 severe bank panic. Since its inception, the Federal Reserve System has served as the gatekeeper of the U.S. economy and the country's central bank. Furthermore, this financial institution regulates other monetary institutions, affects the economy, and controls America's money. The Fed achieves its functions by carrying out various activities that either slows down or stimulate the economy. The main duties of the Fed include conducting U.S. monetary policy, offering financial services and liquidity, and supervising and regulating banks.

Federal Reserve and the Discount Rate:

Discount rate can be described as the interest banks pay when they borrow finances urgently and directly from one of the Federal Reserve banks (Kennon, n.d.). Since the Fed has the ability to affect the direction of interest rates, it also adjusts the discount rate based on a consideration of various factors. Some of the factors that influence the Federal Reserve in adjusting the discount rate include the state of the economy, increase or decrease of money supply, borrowing by commercial banks, and banks' lending activities. The other factor that affects the adjustment of the discount rate by the Fed is the probability that the economy is likely to undergo a recession. While this is not a common factor, it forces the Federal Reserve to decrease the discount rate and establish expansionary fiscal policy. However, inflation can also contribute to adjustments in the discount rate since the likelihood of higher inflation forces the Fed to increase the discount rate and establish contractionary financial policy.

The Discount Rate and Bank Specific Interest Rates:

The discount rate plays a significant and wider role in the overall fiscal policy because it's a vivid announcement of changes in the Federal Reserve's monetary policy. While higher discount rates are indicators of more restraining financial policies, lower rates are signals of less limiting policies. Due to its importance in the economy, the discount rate has a significant impact on decisions of banks in establishing their specific interest rates. Changes in the discount rate not only affect the economy's open market interest rates but they also affect lending rates. The effect on the lending rates either makes it more or less costly for banks to obtain money to lend or hold. Through decreasing or increasing the discount rate, the Federal Reserve System can encourage or discourage borrowing, which in turn changes the revenue banks can obtain for making loans.

Monetary Policy and Inflation:

Inflation is usually a by-product of increases in the supply of money at a faster rate than the underlying economy. On the other hand, monetary policy can be regarded as the process of increasing or decreasing the supply of money. As a result, monetary policy has a significant impact on inflation and demand for goods and services in the entire economy ("How Does Monetary Policy Influence Inflation and Employment?" 2013). Therefore, monetary policy influences the financial conditions experienced by businesses and households.

The significant impact of monetary policy on inflation is evident when the federal funds rate is minimized, which contributes to stronger demand for goods and services. This increases wages and other costs, which is an indication of the huge demand for materials and employees that are needed for production. Generally, monetary policy seeks to avoid inflation through keeping the money supply stable.

Monetary Policy and Money Supply:

Since monetary policy basically involves increasing or decreasing the supply of money in an economy, it is generally used to control money supply. The Federal Reserve uses three major elements to control the supply of money in the U.S. economy. First, the Fed uses monetary policy to control the supply of money through establishing reserve requirements that banks are required to hold. Secondly, money supply is controlled through the purchase and sale of government securities in operations in open market. The third approach that Federal Reserve uses to control monetary policy is through adjusting the discount rate that in turn affects the costs of reserves borrowed by banks from the Fed within the discount window (Beggs, n.d.). The monetary policy instruments used by the Fed influence the supply of credit but do not have direct effects on the demand for credit.

Impact of the Stimulus Program on Money Supply:

The money multiplier is an economic theory based on demand-side and the assumption that every dollar spent by the government will stimulate the economy by 1.5 times the amount of that dollar. This implies that this economic theory assumes that every dollar spent by the government generates $1.50 in economic activity. The use of this theory has been criticized by Keynesians who ignore the supply-side impact in enhancing the demand-side economic philosophy. Generally, the stimulus program through the money multiplier has a negative impact on money supply because of the harmful effects of increased government spending, which causes inflation through printing more money.

This strategy also contributes to the removal of too much disposable income from the economy despite of the government's efforts to spend the country back into economic stability. Actually, reputable economists have continued to criticize the stimulus program through the money multiplier by arguing that the government cannot expand the economy through deficit spending. They also argue that this process requires the government to borrow the money first, which displaces other economic activities. In the long-run, the government affects economic activity without enhancing it in the aggregate. While program contributes to huge short-term benefits, it has negative long-term effects such as inflation because of borrowing and printing more money (Bartlett, 2009).

Indicators of More or Less Money in the Economy:

The amount of money in the economy changes from time to time depending on preferences and other factors that may be economically significant or insignificant. When individuals, businesses, and the government spend money, they stimulate economic growth. The Federal Reserve examines several indicators to determine the presence of more or less money in the economy through predicting slow-downs or inflation. Some of the major indicators of the presence of more or less money in the economy include inflation and economic downturn. For instance, if inflation is high, the supply of money takes place with huge injections than leakages. Monetary policy plays an important role in adjusting the presence of more or less money in the overall economy. The policy develops governmental intervention measures on interest rates and taxation to control the amount of money floating in the economy.