The Federal Reserve, formed in 1913 by the United States Congress, is a formal organization that has the mandate of controlling the monetary policy through carrying out studies and implementation. Before its establishment, the markets were unstable, and the general public had minimal faith in the banking system as pointed out by Meltzer (2010). The Federal Reserve is an independent organization although the Congress can carry out oversight on it. The Federal Reserve is headed by the Board of Governors based in Washington. The chairman and the vice-chairman are appointed by the President to lead the organization but have to be approved by the Senate. The discussion will analyze the role and the effectiveness of the Federal Reserve in stabilizing the current economy, the economic indicators that it should consider to stabilize the economy, monetary policies, and how it affects the demand-supply model.
The Role and the Effectiveness of Federal Reserve in Stabilizing the Economy
The economy of the United States stabilized in the mid-2009, and it is now in its seventh and the last quarter of growth. The gross domestic product (GDP) has matched its peak before the crisis that saw a significant drop in the economy as pointed out by Cecchetti (2009). However, as job growth is still slow and the unemployment rate high, the impact of the Federal Reserve is yet to be felt in full perfection. During the early stages of the initiation of the Federal Reserve, the economic recovery of the country was down to increase in stability of the financial systems, the expansion of the monetary and fiscal policies, and the boost in production that was experienced by the businesses that were rebuilding their inventories. The economic growth slowed down in 2010 majorly because of financial constraints that were caused by interventions to solve Europe’s financial problems. Real consumer spending has increased significantly due to Federal Reserves and investment in equipment and software has taken a toll. The U.S manufacturing industry has also improved markedly due to demand from foreign and domestic consumers. The Federal Reserve has also led to business confidence, accommodative and efficient monetary policies, and good credit conditions that have played a significant role in economic recovery.
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The duty of the Federal Reserve is to ensure that full employment is guaranteed and also to prevent incidences of inflation. Both these aspects are critical in ensuring that the economy of the country is maintained at a stable margin. Due to the financial crisis that has marked the United States, major financial reforms have been carried out within the Federal Reserve. The stabilizing tools that have been employed by the Federal Reserve include the Consumer Protection Act and the Dodd-Frank Wall Street Reform. The efforts of these tools include addressing threats to financial stability, carrying oversight on financial institutions, and improving the ability of financial markets to absorb shock. The Financial Reserve has also developed rules and policies that are economically stable, protect the interests of minor community institutions, and those that can weigh costs and benefits appropriately. Also, the Federal Reserve carry out oversight duties to various institutions they supervise through a particular rule known as the Volcker Rule. This rule prevents banks in the United States from making investments that are not of benefit to their customers. In the supervision of large firms, the Federal Reserve has a duty to oversee and control the financial systems of the organizations. Certain offices are also created that mainly focus on checking the global financial risks and assessing their implication to the financial stability. The Federal Reserve works with the domestic and international banks with the aim of developing firm capital and liquidity policies for internationally active firms. Also, the Federal Reserve has taken certain steps that are aimed at zero-rating short-term interests.
Economic indicators that Federal Reserve should analyze so that it can stabilize the economy
There are two main significant conditions or indicators that the Federal Reserve could utilize in a bid to determine how well to stabilize the economy. They include the unemployment rate and rate of inflation. The third point, which is not very crucial, is the gross domestic product (GDP). The Federal Reserve works hard to ensure that unemployment and inflation rate stay as low as possible, but it does not have a direct effect on these two economic variables. For instance, the Federal Reserve does not have the mandate to tell an organization how many people it is supposed to employ or what price they are supposed to sell their products. However, the Federal Reserve takes advantage of variables known as monetary policy targets which it can affect directly. The monetary policy targets can, therefore, in turn, affect the GDP, rates of unemployment, and prices of commodities that are in tandem to the Federal Reserve policy goals. Monetary policy targets may be in the form of interest rates and money supply. The Federal Reserve majorly uses the interest rate as the main policy target. The best policy setting should be that that guarantees full employment and price stability. The recent crisis faced by the United States outlined that open market operations are not enough to meet the provisions of the Federal's statutory.
The monetary policy has a major impact on production and employment in an economy. By altering the interest rates, the needs for goods and services together with unemployment are affected. When interest rates are lowered, borrowing money becomes more appealing, investment spending will be increased by businesses, and consumers will tend to buy more commodities. The Federal Reserve has an important role of overseeing the United States banks, and in the process, they help in the control of inflation by setting up policies that are geared towards regulating the amount of money hence ensuring that the value of money does not go down.
The GDP can also be a good indicator that can be analyzed by the Federal Reserve to stabilize the economy. The GDP is a measure of the economic production of a given country. It is the amount of value of commodities that a country produces over a specific time. It can be used to gauge the economic health of a given country. Therefore when the GDP of a country is falling, that can be an indicator that the Financial Reserve needs to do more regarding alleviating the economy of the country through monetary policies. On the other hand, if the GDP of a country is on the rise, it is enough evidence that the existing monetary policies of the country are effective and therefore should be upheld.
Monetary Policies That the Federal Government can use to influence the money supply
The Federal Reserve uses three important tools in the management of the country’s monetary system. They include the discount rate, the reserve requirement, and finally the open-market operations as asserted by Campbell et al. (2012). The open-market operations are the most important and also the most flexible among the three. Its importance arises when a shortage or an abundance of reserves is likely to continue, the Federal Reserve may take it upon itself to carry out outright purchases hence making a long-term effect on the supply of the reserves. In an open-market setting, the Federal Reserve can either purchase or sell bonds belonging to the government to increase or reduce the money supply. Most reserve movements are however temporary.
The Federal Reserve can also employ a defensive approach whereby it engages in the business that only leads to temporary effects on the quantity of reserves. In the case scenario where the Federal Reserve Purchases the government bonds, the supply of cash within the system will increase hence enabling it to flow within the to the economy. On the other hand, if they decide to sell their bonds, then the supply of money will drastically reduce. Also, the reserve requirements can be utilized the Federal Reserve to control the amount of money that can be lend out by the banks. The Federal Reserve has the mandate to alter reserve requirements that control the deposits that banks have to retain as vault cash hence affecting the liquidity in the market. If the reserve rate is raised then the banks can retain more money in the reserve.
The discount rate is the last tool utilized by the Federal Reserve. The Banks in the United States may borrow money from the Federal Reserve for many reasons. The discount rate is the amount paid as interest on top of the amount borrowed from the Federal Reserve. When the discount rate is high, banks are discouraged from borrowing funds from the Federal Reserve. The impact will be the reduced supply of cash in the economy. The monetary policy is established to reduce the money supply and thereby to increase the rates of interest. The monetary policies in equal measures can also lower the interest rates hence stabilizing the economy and controlling the growth of the economy.
Monetary Versus Fiscal Policies
The economy is usually kept in control by the use of monetary or fiscal policies. However, these two policies are controlled by different organizations. The two courses of action can influence macroeconomic outcomes according to Dungey and Fry (2009). Monetary policies include the effective management of the supply of money and the interest rates by the central bank. In the stimulation of a falling economy, the Federal Reserve will reduce interest rates making it much affordable to borrow and thereby increasing the supply of money. However, if the economy tends to grow quickly, the Federal Reserve can put certain measures that include increasing interest rates and hence clearing money from the circulation.
Fiscal policy, on the other hand, focuses on how the central government acquires money from taxation and how it puts it to expenditure. In assisting the economy, the government will reduce taxes and thereby increase their expenditure. To alleviate a falling economy, the government will increase the taxes and thereby reducing on its expenditure. There is always a debate that concerning which of the two policies between the fiscal and the monetary policy is best in terms of the country's economy. Each of the policies has its own advantages and disadvantages that can be considered.
With regards to the monetary policy, the Federal Reserve has a mandate to achieve both full employment and economic stability through lowering of prices. When the economy of a country is growing at an alarming rate, the Federal Reserve will put restrictive measures on monetary policy to control the money supply hence reducing the money available in circulation and also reducing the rate at which new money enters the system.
Advantages of the monetary policy system include that the interest rate controls the inflation. Inflation in small amounts can encourage future investment and also enable the workers to expect better pays. Inflation is a scenario where all the prices of goods and services have certainly hiked. When the target interest rate is raised, investment becomes costly hence lowering economic growth. Another advantage of the monetary system is that it can be implemented easily. Federal Reserve acts quickly to use the tools of monetary policy. Also, Federal Reserves are independent and apolitical and therefore even if the monetary policy is not popular it can still be undertaken without the fear of political consequences. Also, weakening the local currency can act to boost the export trade. Increasing the supply of money and lowering the rates of interest will reduce the value of the local currency. This can serve as a boost to export trade as such products will be affordable for foreign buying.
The disadvantages of the monetary policy include the risk of over inflation. When the interest rates are extremely low, people will tend to over borrowing. This can result in a case where the prices of commodities hike. Secondly, the monetary policy has some technicalities such as liquidity trap that arises when interest rates are kept very low for a long period. Finally, the monetary tools such as interest rates tend to have a wider impact and can affect the whole country or state regardless of the people's economic situation.
The advantages of the fiscal policy include the fact that spending can be channeled towards specific projects, regions, or sectors to enhance economic growth. It can use taxation to discourage polluters or those who tend to overuse resources that are limited. The first disadvantage of this policy is that it can lead to budget deficits when it spends way too much money that it gets annually. A deficit can also be created when expenditure is higher than the taxes collected. Tax incentives may also be used on imports hence reducing the amount of money available locally. Finally, the fiscal policy can be politically influenced or motivated. The prospect of raising taxes is not welcome to many people and therefore can be difficult to implement.
Federal Reserve’s Action Impact on Demand and Supply Model
Inflation results when there is increased money and credit in the system. Inflation subsequently results in the recession. Therefore, the role of the Federal Reserve is to carry out financial policies that take care of both situations. The monetary policies have a great impact in controlling the demand and the inflation in the economy. The demand is the level of desire of goods and products. Supply, on the other hand, refers to the capacity of the market or what the market is ready to offer. The economic equilibrium will be arrived at when the demand is equal to the amount of goods and services that are supplied. When the Federal Reserve fails to control monetary policies, interest rates will go down and cash flow in the economy will increase. Therefore the demand for commodities will be higher because of the increased purchasing power. This will affect the economic equilibrium as goods and services will be insufficient in the market. On the contrary, if the interest rates are high and the cash flow is restricted, the supply will be higher than the demand because of the reduced purchasing power. Therefore, the Federal Reserve has a major duty to ensure economic equilibrium through its monetary policies.
To conclude, the Federal bank is the central and independent bank in the United States that make financial policies that ensure that the economy of the country is sustainable. The work of the Federal Reserve is very crucial and can make or break a country. They have a duty to maintain the flow of cash and control interest rates that are geared towards guaranteeing full employment and steady price of commodities.
References
Campbell, J. R., Evans, C. L., Fisher, J. D., & Justiniano, A. (2012). Macroeconomic effects of Federal Reserve forward guidance. Brookings Papers on Economic Activity , 2012 (1), 1-80.
Cecchetti, S. G. (2009). Crisis and responses: the Federal Reserve in the early stages of the financial crisis. The Journal of Economic Perspectives , 23 (1), 51-75.
Dungey, M., & Fry, R. (2009). The identification of fiscal and monetary policy in a structural VAR. Economic Modelling , 26 (6), 1147-1160.
Meltzer, A. H. (2010). A History of the Federal Reserve, Volume 2 . University of Chicago Press.
