Question 1
The federal reserve bank is a major institution in the American’s economy and society designed to offer financial stability by maintaining currency flexibility. The Fed as consistently played a significant role in the Untied States economy and monetary policy since its establishment. The Fed established in 1913, therefore, its the roles and regulations go back only to the early years of the 20th century. For instance, the Fed came into play when a harsh economic crisis started in 2008. During this period the GDP shrank, unemployment increased and millions of Americans were worried about their futures. It was the role of Fed to employ best policy to stabilize the economy (Thomas, 2006). Therefore, the responsibilities and effectiveness of the Federal Reserve in stabilizing the economy are of paramount importance.
Fed is responsible for ensuring an effective monetary policy is employed to stabilize the economy. This is so because its monetary policy function is one of aggregate demand management. It uses the monetary policy to influence the availability and cost of money and credit to enhance the goals mandated by congress. It is the role of the Fed to ensure there are stable price levels and maximum sustainable employment via monetary policy. The Fed’s conventional tool for monetary policy is to maintain the federal funds rate and inter-bank lending rate among others. It influences the federal funds via open market operations in order to stabilize the economy. For instance, in the financial crisis of 2008, the fed lowered the federal funds rate to a range of 0% and 0.25% because it cannot offer a further stimulus via conventional policy (Thomas, 2006). Given the economic changes today, Fed has opted to adopt an unconventional policy to offer a further stability to the economy.
Similarly, the Fed has managed to stabilize the economy via several rounds of large-scale asset purchases of treasury securities and those issued by government-sponsored enterprises. This has managed the Fed’s balance deficit of the financial crisis which affected the economy severely. This policy has managed the price stability and it seen as the first step toward an eventual end to unconventional monetary policy. Short-term interest rates had never reached the zero lower bound before the financial crisis of 2008. Since then it has remained there for years and economist believes it is not wise to use unconventional monetary policy to stimulate the economy. The debate is on ending unconventional policy measures in order to move from the zero bound to enhance economic stability (Thomas, 2006).
Besides monetary policy, government has given the Fed the role of the lender of last resort that ensures continued smooth functioning of financial markets with adequate liquidity. The fed effectiveness is seen in the financial crisis of 2008 when the mortgage automatically resets to much higher interest rates and borrowers found themselves trapped in homes with falling values and no way to refinance. This problem had a significant effect on the financial markets because of mortgage-backed securities. Since Fed has responsibility for monetary policy it managed to restore credit by increasing the money supply and pushing interest rates up.
Question 2
In deliberating about economic issues, economist agrees on particular goals, which include economic growth, decrease in the unemployment rate and low inflation. In order to attain these goals, the federal reserve is supposed to regulate these economic indicators. This is so because unemployment, GDP and inflation are the main economic indicators that Fed should analyze in order to stabilize the economy. By examining these indicators, Fed will be in a position, whether to employ fiscal, monetary policies or regulatory and trade policy to stabilize the economy. Fiscal policy concerns taxes and spending while monetary policy involves the supply of money and the level of interest rates. Similarly, regulatory and trade policy involves a wide range of methods by which government policies affect markets for commodities.
In order to stabilize the economy, Fed should evaluate the real GDP, which is the market value of the commodity produced during a particular period. It measures the nation’s wealth by showing how income may grow and the expected return on capital. Therefore, the real GDP is the main economic indicator because it gauges the health and stability of the economy. The federal reserve can utilize the data such as GDP to adjust its monetary policy. The federal reserve works under a legal mandate that targets balanced growth and full employment, as well as the price stability.
Another economic indicator is inflation, which affects the price of commodities. The constant move to expand the economy in the short run put pressure on constraints that result in higher inflation without reducing unemployment rate or increasing GDP. High inflation should be discouraged because it can obstruct economic growth due to instability of price levels. In additional, employment is another economic indicator that Fed considers when implementing the monetary policy. Although the monetary policy cannot affect the employment and output in the long-run, it can influence them in the short-run. For instance, when aggregate demand decreases, the fed can stimulate the economy by decreasing interest rates. Therefore, inflation, employment and output are the main economic indicator that influences the use of monetary policy.
Question 3
The monetary policy has two primary goals which include promoting sustainable output and employment as well as enhancing stable prices. For the Fed reserve to maintain these goals it has to employ monetary policy that involves the supply of money and interest rates. This is so because its role is to manage the excess reserves and credit to maintain economic stability. For instance, when the economy is sputtering and unemployment is high, the Fed may seek to lower interest rates. This easy money will allow business to borrow in order to expand their activities, thereby creating employment. In additional, consumers respond to lower rates by increasing purchases of costly items that require loans such as homes and cars. However, when inflation is high, the Fed may seek higher interest rates to reverse these effects and stabilize the economy. Therefore, when the Fed acts to deliberately to manage excess money supply and interest rates in order to influence the levels of output, employment and prices in the economy, it is engaging in monetary policy. This is so because when the economy has unacceptable rates of unemployment, the total spending is supposed to be stimulated. To achieve this, the Fed would act to increase the money supply in the system, decrease interest rates and encourage borrowing. When the Fed takes action of expanding the money supply, it is pursuing an easy money policy. In contrast, when the economy has demand-pull inflation, the effective policy recommended is to reduce spending. In this case, the Fed would respond by decreasing the level of excess money supply in the system, increase interest rates and dampen borrowing. Therefore, when the money supply is deliberately decreased, the Fed is said to employ a tight money policy.
The Fed uses three major tools to change excess money supply in the economy and control interest rates. The Fed can reduce the money supply and discourage borrowing by increasing the reserve requirement. In contrast, a decrease in the reserve requirement would lead to increase in the money supply, based on the ability of making new loans. This is so because a decrease in the reserve requirement would supply the institutions in the system with excess reserves, which would stimulate the economy. On the other hand, an increase in the reserve requirement would decrease the money supply to this institution, which would fight demand-pull inflation effectively.
The fed can use a discount rate to regulate the money supply to promote economic stability. This is the rate that the reserve bank charges a financial institution for borrowing reserves. An increase in the discount rate increases the price of the reserves, thereby discouraging money borrowing. On the other hand, a decrease in the discount rate is an attempt of the Fed to encourage borrowing. The Fed announces discount rate changes publicly. For instance, an increase in the discount rate reflects the attempt to tighten the money supply, which can deal with the demand-full inflationary pressure (Welch, 2009).
The fed can stabilize the economy using the open market operations. Thus, the most used tools for changing excess reserves in the financial institutions. This tool involves buying and selling of the United State government securities on the open market by the Fed. The open market operations offer a significant tool for enacting monetary policy in two ways. First, the change of the money supply can be achieved faster because operations are done on a daily basis. Second, the quantity of the money supply can be altered slightly or greatly based on if the government securities are bought or sold in small or large quantities. Therefore, open market operations can aim at maintaining excess reserves and interest rates in order to stabilize the economy (Welch, 2009).
Question 4
Monetary and fiscal policies are the primary macroeconomic tools by which the Fed can influence the performance of the economy. The Fed can increase aggregate demand for real output via expansionary monetary or fiscal policies. For instance, the two policies were used during the financial crisis to stabilize the economy because they aim at increasing the nation’s real GDP and reduce the unemployment rate, as well as stabilizing prices. In the case of the inflation, the Fed can use contractionary monetary or fiscal policy to reduce the level of aggregate demand. However, monetary policy has some limitations that make the policy makers prefer fiscal policy.
The monetary policy causes the crowding out effect on the private sector. This happens when borrowing by the Federal government increases the interest rate and reduces borrowing by households and business. The increase in the interest rate that arise from government borrowing deprive business and household ability to borrow which lead to decrease in private borrowing (Welch, 2009). Another limitation of the monetary policy is that it does not control the amount that the financial institution chose to lend. This is so because when the money is in the financial bank it creates much money only when the bank loans it out. Since the banks can opt to hold excess reserves, the Fed cannot be certain how much money in the banking system will create. For instance, the banking system creates less money due to bankers’s decision, the money supply will decrease. Therefore, the amount of the money in the economy depends on the bankers behavior because Fed cannot control or predict this behavior, which causes the inefficiency of the monetary policy in controlling the money supply.
In additional, the fed cannot control the amount of money that the individual decides to hold as deposits in banks. The more money the household deposits, the more money supply the banks will have in the banking system. Similarly, the less the money households opt to deposit, the less money supply the banks will have in their banking system. The problem arises where the individual opt to withdraw deposits and hold cash. When this happens the bank institutions loses money supply and create less money. Therefore, the money supply decreases without any Fed action. On the other hand, the fiscal policy can be used to eliminate the crowding effect on the private sector because it increases government spending and taxes. However, taxes can also slow economic growth and put a severe burden on individuals and business.
Question 5
The aggregate demand-aggregate supply model is the macroeconomic model used to demonstrate the price level and output in the economy. We will evaluate the effect of monetary policy on the aggregate demand and aggregate demand supply in the Keynesian model. The aggregate demand indicates the sum of government spending, net exports, investment and consumer spending. The aggregate demand assumes the money supply is constant. However, changing the money supply influences the aggregate demand curve.
When the Fed decides to employ the contractionary monetary policy, it reduces the money supply in the economy. The decrease in the excess reserves leads to an equal decrease in the GDP. Similarly, a decrease in the money supply causes a decrease in consumer spending and investment. This decrease of the money supply as a result of contractionary monetary policy causes the aggregate demand curve to shift to the right (Mankiw, 2012).
On the other hand, when the fed decides to use the expansionary monetary policy, the money supply in the economy increases. The increase in the money supply lead to an equal increase in the GDP as well as consumer spending and investment. In this case, the aggregate demand curve shift to the left. The expansionary monetary policy leads to lower interest rates. These lower interest rates encourage investment, which has multiplier effects on the aggregate demand. For instance, by contracting bank reserves and the money supply, the fed can force interest rates to increase, which lead to decrease in investment spending and pulling down the aggregate demand. Therefore, the effect of monetary policy on aggregate demand is based on the interest rates on the investment spending.
The expansionary monetary promote total spending because it increases the aggregate quantity demanded at any given price level (Mankiw, 2012). However, in order to understand what happens to GDP and the price level, the analysis of aggregate supply is vital. The expansionary monetary policy causes inflation under normal situation. However, the magnitude of the inflation depends on the slope of the aggregate supply curve.
References
Mankiw, N. G. (2012). Principles of macroeconomics. Mason, OH: South-Western Cengage Learning.
Thomas, L. B. (2006). Money, banking, and financial markets. Mason (OH: South-Western.
Welch, P. (2009). Economics: Theory and practice. Hoboken, N.J: Wiley.
