MonetaryPolicy and the Federal Reserve
Monetarypolicies are macroeconomic tools of stabilization employed by theFederal Reserve, the central bank or other regulatory bodies tocontrol the quantity of money as well as the credit in the economy soas to ensure the stability in price. "Anything that affectsmoney and credit also has an impact on interest rate, the cost of thecredit as well as the performance of the economy"(Samiksha).Monetary policy is sustained through actions such as buying andselling of government bonds, modifying the interest rates, andcontrolling the amount of money held by the commercial banksalongside other measures.
Types of monetary policy
Twodistinct types of monetary policy are used to combat differenteconomic issues, they include:
Theexpansionary monetary policy alsoknown as the easy monetary policy. It refers to the increase in moneysupply to reduce unemployment, promoting private-sector borrowing aswell as consumer expenditure which boost the overall economic growth.In this case, central bank attempts to encourage total demand whichis the sum of private and government spending and imports. Raisingthe amount of money in the economy reduces the interest rate whichfosters loaning and investment. An increase in expenditure andinvestment increases the total demand. "The expansionarymonetary policy encompasses actions such as purchasing U.S Treasurysecurities via open market operations, a cut in the bank rate and areduction in the reserve requirements" (Jason,170-180).In this case, it is crucial for interventionists to make constantdeclarations. If private consumers and companies note that theinterventionists are focused on expanding the economy, they expectfuture prices to increase. Hence, they will alter their long-termoperations, by borrowing out to advance their businesses. On thecontrary, if they note that the central bank`s activities are a shortwhile, they will not adjust their operations, and in return, theanticipated effects of the expansionary plans will be reduced.
Thecontractionary monetary policyfocuses on reducing the amount of money supply in the economy tomanage inflation. At times contractionary monetary policy can reduceeconomic growth, elevate the rates of unemployment as well as reducethe credit availability and expenditure rates by both consumers andfirms. An example was the Federal Reserve’s involvement during thebeginnings of the 1980s to control inflation that had rose to 15%.The U.S central bank increased its benchmark interest rates to 21%which led to the recession but helped to reduce inflation to someextent. Contractionary monetary policy is necessary when the economyis in expansion and inflation is an issue. The tools used in thiscase include selling of US Treasury securities via open marketoperations, a rise in the bank rate and increase in the reservenecessities. "These actions move the AD curve to the leftreducing the inflation" (Jason,170-180).Change in money supply affects the amount of money in circulation inthese procedures. A decline in money supply raises the interest ratestolessen the level of investment. In return, aggregate demand decreaseswhich cause a decrease in real GDP leading to rising in theunemployment, prices, and inflation.
Objectives of Monetary Policies
Thefollowing includes the primary aims of the monetary policy:
Fullemployment:It is a crucial goal because unemployment results to wastage ofpotential output as well as loss of social standing and self-respect.The increase in consumer expenditure leads to increased businessrevenues and profits. In return, it allows firms to incorporate newplant and equipment as well as recruit new workers. "During theexpansionary monetary policy period, unemployment decreases sincecompanies deem it easier to borrow money and expand their operations"(Labonte).Asmore individuals find employment, their spending increases which inturn raises revenues and results in more jobs.
PriceStability: Accordingto Keys "price stability is perceived as the most fundamentalobjective of the monetary policy since it raises people`s assuranceas cyclical oscillations are eradicated." In return, itencourages business actions and makes sure that there is an equalallotment of income and possessions. This equity makes sure thatthere is a universal wave of affluence and welfare in the society.Price constancy also "obstructs economic development since thereis no inducement available to the business persons to raisemanufacturing of qualitative commodities. It dampens exports andpromotes imports" (Labonte).
EconomicGrowth: Economicgrowth refers to the process where the real per capita earnings of anation raises over an extended time. It includes an increase in thesum of real and actual output and the generation of products for thefulfillment of human needs. It also comprises of exploitation of allthe industrious, natural as well as capital properties in a way thatensures a continued rise in countrywide and per capita takings overtime. The monetary policy encourages a maintained and continuouseconomic development by upholding equilibrium between the overalldemand for currency and overall production capability as well asinstituting favorable circumstances for saving and investment. Themonetary policy also helps in bringing equality between demand andsupply. Monetary authorities should, therefore, adopt an easy ortight economy to suit the growing demand for money.
Stabilityin the Balance of Payments: Exchangerates disequilibrium occurs due to the problem of global liquidity onaccount of the growth of international trade at a higher rate thanthe global liquidity. The rise of a deficit in the balance ofpayments reduces the potential of an economy to attain otherobjectives. As a result, many less developed nations have to limittheir imports which negatively affect development activities. Thus,any monetary authority needs to incorporate all measures that ensurestability in the balance of payments is sustained.
Neutralityof Money: MonetaryAuthorities should aim at maintaining the neutrality of money in theeconomy. Any monetary alteration is the cause of overall economicdistortions. According to the neutralists, the fiscal change resultsin the distortion and disturbances in the proper functioning of thefinancial system of the nation. By maintaining the neutrality ofmoney, there will be cyclical fluctuations, no trade cycle andinexistence of inflation and deflation. Hence, monetary authorityshould ensure the amount of money is perfectly stable (Samiksha).
Instruments of Monetary Policy
Thetools of monetary policy can be categorized in two distinct forms.They include quantitative or indirect and qualitative or directsystems. However whether direct or indirect, they focus oninfluencing the overall level of aggregate demand through the supplyof money, interest rates as well as the accessibility of credit. Thefirst category includes the open market operations, reserverequirements, and bank rate policy. This set is aimed at regulatingthe overall level of money in the economy through commercial banks.The second category, focuses on monitoring specific kinds of credit,they include, altering the margin requirements and control ofconsumer credit. They are discussed in detail below:
BankRate Policy: Itis the interest rate at which the US federal bank loan out funds tothe commercial banks mostly in the form of very short-term loans. Controlling the bank rate is the technique through which the UScentral bank affects economic activity. Lower rates help to boosteconomic growth by decreasing the cost of monies for borrower whilehigh bank rates aid in curbing inflation. In America, the bank rateis known to as the federal fund`s rate or the discount rate. Theboards of governors of the Central Bank are tasked with theresponsibility of setting the bank rates and reserve requirements forthe commercial banks. Bank rate function in the following manner. Ifthe Federal Reserve discovers inflationary forces have begunsurfacing within the nation, it raises the discount rate. In return,loaning out from the central banks by the commercial banks becomesexpensive, and business banks hence borrow less money. Commercialbanks, as a result, raise their lending rates to their clients, whichdecreases borrowing rates in the overall economy. This lead to thecontraction of credit as well as a reduction in the prices.Conversely, prices decreases, the central bank lowers bank rate.Early September 2007, the federal funds` target was dropped fromaround 5.19 percent to a range of 0- 0.28 percent in December theyear 2008. Economists refer this zero lower bound. In 2015, December,the Fed started increasing the cost of credit and anticipates keepingon increasing the rates further.
Openmarket Operations: Itentails selling and buying of securities in the money market by thecentral bank. The Fed uses the open market operations as itsprincipal instrument to control bank reserves. "In the US, Openmarket operations are executed by the nation`s Trading Desk of theCentral Reserve and the Bank of New York under the management of theFOMC. These transactions are then perfumed by the primary dealers"(Goodwin& Torres, 400).
Whenprices are increasing, the central bank sells financial securitiesoften issued by the U.S Treasury, government-sponsored organizationsand Federal agencies. The reserves of the commercial banks arereduced as a result since banks are not able to lend more to theirclients. Investment is discouraged which reduces the prices. On thecontrary, when the Fed needs to increase the reserves, it buys backsecurities and makes payment in the account managed by the CentralBank by the chief dealer`s bank. Commercial banks enhance theirlending rates and in return, investment increases which boostemployment thus increasing the prices if product and services.
ReserveRequirement ratio: Thisis the quantity of money depository bodies are obligated by theCentral Bank to have in the form of reserves over the deposits. Itset out of the amount of currencies banks generates through loans andinvestments. The Boards of Governors institute the rate and it isgenerally about 10%. This rate means that even though particular bankkeeps, let say $ 20 billion in the form of deposits for all itscustomers, the same bank cannot loan out nearly all of this moneyand, thus, it does not own that $20 billion. Surplus reserves arekept as vault monies or in accounts with the Central Bank. In theinstances when the economy is experiencing high prices, the Fedelevates the reserve ratio. Commercial banks are necessitated to holdmore with the Fed. Their reserves are decreased, and they hence loanout less. The amount of investment, production, as well asemployment, is negatively impacted. On the other hand, when thereserve ratio is decreased, the reserves of the commercial banks arereduced. They hence loan out more which boost the country`s economy.
SelectiveCredit Controls: These controls are utilized to influence certain kinds of credit forcertain reasons. They typically take the form of varying marginnecessities to manage speculative actions within the country. In thecases of brisk uncertain doings in the nation or particular sectorsin some commodities and prices start increasing the central bankelevates the margin requirement on them. In turn, "borrowers aregiven less quantity of money in the form of loans against particularsecurities" (Goodwin& Torres 400).
Effectiveness of Monetary Policy
Itis crucial to explain the extent to which a monetary policyinfluences the level of national output. The Federal Bank affects thedegree of employment, production, and income through monetary policy.It does this by rising or lessening the amount of currency in theeconomy. The increase in money supply as discussed above isexpansionary monetary policy and is indicated by the outward movementof the LM curve. Reducing amount of currency in the economy is knownas the contractionary monetary policy is indicated by the inwardshift of the LM curve. Let say the nation is in balanced at positionE, OY being the earnings and OR the interest rates. Any rise in themoney supply moves the LM curve to LM1giventhe IS curve. In return, it decreases the interest rates from OR toOR1raisingthe investment and the national income. Hence, the countrywide incomeincreases from OY to OY1.
Theefficiency of the monetary policy is determined by the nature of theLM curve and the IS curve. Monetary policy is most effective if theLM curve is steeper meaning the demand for currency is less interestelastic. Hence there is a larger decrease in the interest rates whenthe amount of supply is raised. In the instances when demand forcurrency is deemed to be slightly elastic to an adjustment in thecost of credit, a rise in the cash supply is greater resulting in agreat decline in the interest rates. A significant decrease in theinterest rates leads to greater savings and national earnings. Thisresponsiveness is shown in diagram 2. E is the initial equilibriumpoint of the nation and OR cost of credit and OY returns. When theLM1arcmoves to outwards to the LMS,thecurrent balance is instituted at E2.Consequently,the interest rates decrease from OR to OY2andreturn increases from OY to OY2.On the contrary, the flatter is the LM graph, the less efficient isthe monetary policy. The greater interest elastic is the claim formoney the less is the decrease in the interest rates when the amountof money is raised. A small decline in the interest rates results ina lesser rise in the investment and earnings.
Indiagram 2, E is the initial balance point, and OR is the interestrates and OY as returns. When LM2curve moves to theLMF, thecurrent balance is set at E1which generates OR1interest rates and OY1income level. Thedecrease in interest rates to OR1is less than OR1in the more steep LMScurves and rise in returns OY1is less than OY2in the steeper curve.This demonstrates that monetary policy is less effectual in theinstance of the flatter LM curve and more efficient in the case ofthe steeper curve (Chandra & Unsal, 13).
Ifthe cases when the LM curve is horizontal, monetary policy isentirely unsuccessful since the demand for money is perfectlyinterest-elastic. This is the scenario of the liquidity trap as shownbelow where the rise in the quantity of money supply does not affectthe interest rates OR
andthe income level OY.
Conversely,if the LM curve is vertical, monetary policy is hugely successful inthe demand for money interests inelastic. Diagram 3 indicates thatwhen the vertical LM curve moves outwards to the LM with the increasein the quantity of money supply, the interest rates decreases from ORto OR1.This does not affect demand for money and the overall rise in themoney supply does not have an impact on the increase in the incomelevel from OY to OY1.
Inthe case of the interactions of the IS curve and LM curve, monetarypolicy is successful in the case when the IS curve is flatter. Theflatter IS curve indicates that the investment spending isexceedingly interest elastic. The rise in the money supply decreasesthe interest rates to some extent private investment also increasesby a significant amount of income. This is indicated below indiagram, 5.
“Theinitial balance is at position E with the OR interest rates andincome level being OY. When the LM curve moves to outwards to LM1with the rise in the money supply, it meets the flatter curve ISFat E2which generates OR2interest rate and OY2returns. Theequilibrium point when the ISsis steeper, theinterest rates OR1, aswell as income level OY1,are lesser than thoseof more flat ISF curve.In comparison with the steep IS curve hence making monetary policymore effective” (Chandra & Unsal, 13).
Insummary, for an effective anti-cyclical monetary policy, bank rate,market operations, selective credit controls and reserve ration areadopted concurrently. Nevertheless, it has been agreed upon by themonetary theorists that, the effectiveness of the monetary policy iszero in a depression when the business confidence is at lowest. Also,monetary policy is effective against inflation. The monetarists arguethat as against fiscal policy, monetary policy has superiorflexibility and it can be executed rapidly.TheFed tries to alleviate systematic risk and avert financialinstability through regulatory duties and its lender of last resortsactions. In this context, it is worth stating the policy ofquantitative easing (QE) which the Federal Reserve of United Statesis adapting to stimulating the American economy managed Governor BenBernanke. Under this policy, the Federal Reserve has consistentlybeen purchasing securities from since 2010 and pumping into the USeconomy more money on an extensive scale maintain zero rates ofinterest. The quantitative casing seems to have a function inelevating the levels of output and employment in the US and henceattaining recovery of the American economy in the year 2013 with therate of unemployment declining to 7.6 percent in comparison to 10percent in 2009.
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