The Federal Reserve primary goal is to stabilize the U.S. Economy. In this regard, the Federal Reserve functions as the traditional central bank in which it controls inflation without causing an economic recession. The Federal Reserve, therefore, facilitates the implementation of the monetary policies. The Federal Reserve, therefore, implements contraction monetary policies to control inflation and slow economic growth that is associated with increased prices of general commodities. Ordinarily, the economic growth rate of any economy is expected to range between 2-3 percent. Low levels of inflation measured by a low consumer price index (between 1 to 2 percent) are beneficial to a country since it reduces the severity of economic recession by enabling labor markets to adjust quickly to the recession thereby reducing the risk of liquidity traps (Goodfriend, 2007). The low levels of inflation will also enable the economy to avoid cyclical fluctuations in the U.S. economy that may result in massive unemployment and other negative economic growth. Moreover, low inflationary levels provide an economic environment that is relatively optimistic for investors.
The low inflation increases the level of investment that increases the aggregate supply in the end thereby increasing the rate of economic growth, especially in future. The government should maintain the levels of inflation to be as low as possible to ensure increasing economic growth. If inflation rate increases above 4 percent, then the economy may experience an economic boom in the end. Such levels of economic growth are unstable and highly unsustainable (Goodfriend, 2007). Unfortunately, the economy will after that experience economic recession. The best illustration of such economic crisis occurred in the United Kingdom in 1991 recession that occurred after the Lawson economic boom experienced in the mid-1980s. In this regard, the high inflation in the U.K. resulted in high prices of general commodities. Therefore, the inflation made U.K. products to be more expensive resulting in decreasing the level of exports since U.K. products were less competitive on the global market compared to other products. The decrease in the levels of exports resulted in decreasing in the value of the economy's current account resulting to an unfavorable balance of payment (Goodfriend, 2007).
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Role of Monetary Policies
Economists believe that inflation can be controlled using monetary policies. In this regard, these policies attempt to lower the level of currency in circulation within the economy thereby alleviate the economic recession. The major factor that causes inflation is the increasing demand for commodities can push up prices of general goods and services resulting in inflation whereby the growth rate of the economy increases by over 3 percent.
In the event of inflation, the economy has a lot of currency in circulation as well as high availability of credit from commercial banks. The Federal Reserve will, therefore, slow the rise in prices of commodities by limiting the amount of money in circulation as well as tighten the credit availed to circulation by the financial institutions. In this case, the Federal Reserve reduces the level of liquidity in the U.S. economy by making it relatively more expensive for investors and individuals to borrow loans from financial institutions (Woodford, 2011). The move slows down the level of economic demand for products thereby pulling downward pressure on prices.
The Federal Reserve will implement contraction monetary policies such as open market operations, where it sells government securities (in the form of treasury notes) thereby reducing the amount of money in circulation. Moreover, the Federal Reserve can increase the bank interest rates to discourage individuals from borrowing and encourage more savings and investment. Lastly, the Federal Reserve can impose restrictive reserve requirement to lower some funds available for lending (Woodford, 2011).
References
Goodfriend, M. (2007). How the world achieved consensus on monetary policy. The Journal of Economic Perspectives , 21 (4), 47-68.
Woodford, M. (2011). Interest and prices: Foundations of a theory of monetary policy . princeton university press.
