The Role of the Federal Reserve on the Economy (Essay Sample)

Name Instructor Class Date The Role of the Federal Reserve on the Economy Introduction Following a series of financial crisis, panic, and banking runs, the Congress passed the 1913 Federal Reserve Act and was signed by the then president Woodrow Wilson, which created the Federal Reserve System. The Federal Reserve comprises of twelve public-private district Federal Reserve banks. The Federal Reserve is tasked with the management of U.S monetary policy, which regulates bank holding companies and other financial institutions and monitor systematic risks. A board of governors manages the Federal Reserve. The President selects the board members and subject for approval by the Senate. The Congress has entrusted the Federal Reserve (Fed) with the monetary policy responsibilities though it oversights to make sure Fed adherers to the statutory mandate of maximum employment stabilizing prices and moderation of interest rates. The Fed acts as the Central Bank in the U.S. The Fed's responsibilities fall into four major divisions. They include monetary policy, providing emergency liquidity by acting as the lender of last resort, supervising financial institutions, and providing payment system both to the government and to financial institutions. A change to the amount of money and credit in circulation will affect the interest rate and the economy at large. The Fed's monetary policy role is among the much collective demand management. Monetary policy refers to the actions that the Fed undertakes in order to manage the amount of money and credit in circulation in the U.S economy to uphold the goals and objectives that it is mandated to carry by the Congress – stable prices and maximum sustainable level of employment. The expectations of both the consumers and businesses have a greater influence in the expenditure trends in U.S, which are themselves influenced by the measures taken by Fed. Therefore, a broader description of monetary policy would incorporate directives, policies, economic forecasts, and the measures by the Fed. The Federal Open Market Committee (FOMC) assembles occasionally to review the current position of monetary policy. From 2007-2008 financial crisis that hit the economy, direct lending become crucial once more both through the discount window and other means that the Fed created. This means injected funds, credit, and liquidity to depository banks and loaning to other institutions that does not belong to depository banking system. As the situation continues to normalize, the emergency lending has been cut down with an exception of foreign central bank liquidity swaps. Currently the US economic freedom score stands at 75.5% and is 12th in terms of freest economies according to 2014 index and the economic conditions continues to stabilize. The main role of Fed is to ensure sufficient availability of money and credit for a continued economic growth and development while regulating inflation. To achieve this, Fed uses various tools and means – both traditional and unconventional methods. They include discount rate, reserve ratio requirements, and open market operations. This paper reviews and discusses the role of Fed in the national economic goals particularly to unemployment, inflation, and economic growth using the various tools and means. It discusses the tools that Fed uses to stimulate the economy both traditional and nontraditional. How the Fed Utilizes its Mandate to Achieve its Goals through Various Tools Open Market Operations: This is majorly elastic and it is the primary method used fiscal policy tool by the Fed to control money and credit. It involves sales and buying of U.S Government Treasury Securities. The FOMC sets the monetary policies, which are implemented by the Federal reserve of New York. When the committee reaches a consensus to increase the amount of money and credit in circulation, Fed purchases the existing Securities from the open market crediting the accounts of the financial institutions that participated in the transactions. It buys the Securities using newly issued currency. This expands the reserve base of financial institutions and they have more ability to lend on low interest rates to encourage and attract borrowers. This raises the amount of cash and credit in the flow. On other hand, if the Fed wants to contract or reduce the amount of money in circulation, Fed sells the government securities. This condenses the amount of cash in the flow. The Reserve Requirements: Fed requires financial institutions to keep a certain percentage of their total deposits and hold it in Reserve Banks irrespective of whether they are associates of the Federal Reserve System. The reserve can be either cash or deposits at the Fed. The Fed has the go-ahead to set the ratio. If the reserve ratio is increased, banks are left with smaller amounts of money and credit to their disposal and to lend. This reduces the amount of money and credit that is circulating. On the other hand, when the Fed lowers the reserve requirements, banks have more money to lend, which raising the availability of money and credit. Currently the rate stands at within the range of 0% and 10% depending on the size of the financial institution. The Reserve requirement is not used regularly as a monetary policy tool – the rate was updated lastly in 1998. The Discount Rates: The Fed allows financial organizations to borrow money and credit from it directly on a temporary basis at the discount window. This means that, the institutions can discount some of their own assets to the Fed so that it can give them a short reserve access. The Fed charges an interest rate (Discount rates) on these advances. Unlike in the open market where the interest rates are determined by the interaction of forces in the financial market, the rates are determined by the directors of the Federal Reserve banks and subject for adoption by the board of governors. Any adjustment in the discount rate hinders or encourages banks to lend and indirectly affects the rate banks pay to their depositors and charges to their borrowers. Moral Suasion: In this case, the Fed uses persuasion and request to depository banks to control money and credit availability. To reduce inflation, Fed persuades depository banks to cease from lending for speculative and non-essential reasons. On the other hand, to overcome deflation, the Fed persuades the deposit banks to broaden credit availability to various purposes. In this regard, Fed asks the financial institutions to cooperate with it to attain monetary policy goals and objectives. The Fed has been encouraging depository banks to expand their lending capacity to businesses for a sound economic growth and recovery. Due to the recent economic recession that was experienced in 2007, the Federal Reserve lowered the federal rate to a range of 0% and 0.25%, which is referred to as zero lower bound. The Fed cannot lower the rate beyond this point to stimulate growth. Since then, the rate has not been changed and will continue to be like that until unemployment rate goes below 7%. Furthermore, the Fed stretched its liquidity services. This was a move directed to ensure that financial institutions had access to funds that they require for their daily operations. Under the normal situations, the Federal Reserve provides loans only to depository banks – through discount window lending. However, in 2008, investment banks that included dealers of government securities were faced with a challenge of accessing short term funding and became vulnerable. To counter this financial shock, the Fed expanded its credit facilities to non-bank institutions and to some of the financial markets, which has seen the economy, improve. The Fed also innovated and made liquidity available through auctions and standing facilities to overcome businesses' unwillingness to borrow from the Federal Reserve by fearing that the borrowing could be a plan by market players and portrayed as an indicator of financial fault. In this case, firms have to place their bids on the rate of interest they would wish to pay for the cash they borrow – which is different from discount window, which publicizes the institutions need for credit, which may raise solvency fear to some depositors and economic stability at large. As an extra tool to counter balance sheet concerns, the Fed introduced Securities Lending facilities, which allowed financial institutions to exchange out mortgage-backed collateralized debt obligations (CDOs) with U.S Treasuries. The Fed has acted to improve the state of two vital markets that fell during the recession – money market mutual funds and short-term lending to businesses. The money mutual funds accumulates credit from investors and avails the funds to short-term undertakings like Treasury bills and availing credit to borrowers on short-term basis without security, known as commercial paper. At some point, investors started pulling out of the mutual funds due one of the market players being declared bankruptcy. This caused interest rates to rise affecting the market at large. Fed availed secured loans to the institutions in these markets, a move that ensured adequate funds. The Federal Reserve's Set of Unconventional Monetary Policies Large Scale Asset Purchases (Qualitative Easing –QE) The fed enacts quantitative easing by producing money and uses the money to purchase bonds, securities, and other assets from depository banks. In this case, depository banks have extra cash available to them for lending. In addition, the Fed's involvement in buying securities drives up their prices due to the reduced supply. This causes their returns to be low, which in turn stimulates the economy by reducing rate of borrowing. In 2009, demand for credit from the Federal Reserve started to decrease as economic state stabilized. At the same time, t...