Introduction
The United States established the Federal Reserve institution in 1913. This central bank was responsible for safeguarding the economy of the United States by raising and lowering the interest rates that the borrowers have to pay to the lenders (Grey, 2002). This paper will determine how exactly the Federal Reserve is controlling the interest rates. It also examines why the interest rates influence the broader economy of the U.S. However, before the establishment of the Federal Reserve Bank, there was economic panic, and this was caused by emergency banking that was the common events as the prospective investors would lose confidence concerning the safety of their deposits in banks.
In controlling this sense of financial instability, the Congress House in the United States, certified almost twelve leading national banks to issue the legal Federal Reserve notes that was also famously known as the paper money. Additionally, the Federal Reserve was established to make adjustments on the lending rates so that the borrowers could be charged by the banks, and to buy and sell the U.S treasuries (Keefe, 2013).
Inflation, interest rate, and the economy of United States
As the demand for labor increases, employees will begin to ask for additional salaries and this will lead to higher rate of inflation (Capistran, 2016). On the other hand, when the price of goods increases, then the value of money will decrease. Therefore, consumers will not be capable of buying many products and other services as before. Consequently, lack of demand from the consumers and businesses may lead to contraction of the economy, resulting in unemployment cases. It is the duty of the Federal Reserve to maintain stability in finances throughout the growth and contraction by making proper adjustments in interest rates. As the rate of interest increases, there will be a decrease in the value of money and the Federal Reserve should control this by increasing the interest rates. Moreover, when the unemployment rate is high at the time the economy is stagnant, the Federal Reserve will reduce the interest rates to spur the economic growth.
According to the website of Federal Reserve, when interest rates are manipulated, a chain of events will be triggered and this will influence the short-term interest rates, rates of exchange, foreign exchange rates, and a range of economic variables such as employment, and prices of goods and services (FRB, 2016). Moreover, as shown by the history, the impacts of uncertainty due to severe financial crises can initiate periods of the greater economic condition. Consequently, these unstable periods became uncommon in the United States as the economy experienced periods of economic expansion in the last century.
Monetary policy and the economy of United States
The Federal Reserve have created the monetary policy of the country to promote the aims of maximum employment, the stability of prices, and the moderate long-term interest rates. However, the policy-makers may face short-term tensions and the information concerning the economy may be available with only a lag and this may be imperfect. According to the Federal Reserve Act, its objectives specifies that it is the duty of the Board of Governors and the Federal Open Market Committee (FOMC) to promote the goals of maximum employment, stable prices, and the long-term interest rates (FRB, 2016). Additionally, the longer stability of prices is a pre-condition for good sustainability in the growth of output, employment, and the moderate long-run interest rates.
When prices of the products are stable, and they are believed to remain stable, then the value of the goods and services and labor will not be distorted by inflation. Therefore, this will be a clear indication that guides the efficient allocation of resources, thus contributing to higher standards of living in the United States. The price stability will encourage the formation of savings and capital because when the risk of asset erosion due to inflation, and the need to protect the losses are minimal, then the households will be encouraged to save more as the business is also encouraged to venture into more investments. Moreover, price stability can assist in achieving maximum sustainability of the growth in output and employment in the long run. However, there can be some existence of tensions between the two objectives, and slowing employment growth will be accompanied by reduced price pressures and the countering of the weak labor market by easing the monetary policy does not have an adverse influence on the inflationary effects.
The impacts of the monetary policy on the U.S economy
The market balances that are held at the Federal Reserve Banks is the main link between the monetary policy and the economy. All depository institutions are holding accounts at their Reserve Banks and the actively balance their trading activities held in these accounts in the Federal Funds Market at an interest rate called the federal rate of funds. The Federal Reserve will practice considerable control over the federal funds rate via its guidance over the supply and demand for the balances at the Reserve Banks (Dudley, 2016).
The FOMC will set the rate of federal funds at an appropriate level that will nurture both financial and monetary conditions to be consistent with the achievement of its monetary policy objectives as it adjusts that target in line with the developing economic situations (FRB, 2016). As the rate of federal funds changes due to future expectations of the federal funds, it can set off a chain of events that will influence other short-term interest rate and the value of the foreign exchange to the dollar and the stock prices. Therefore, as the variables changes, the spending decisions of the households and businesses will be affected, thereby affecting the aggregate growth in demand and the economy.
The current level of the federal funds rate and the expectations concerning the federal funds rates will affect the short-term interest rates over the period of the short term contract. This effect will make the short-term interest rates to decrease if the surprised market participants decrease with a reduction in the federal funds rate. The changes in short-term interest rates will affect the long-term interest rates like Treasury notes, fixed rate mortgages, consumer loans, and corporate bonds. Besides, the long-term rates will be influenced by the changes in present short-term rates and the expectations regarding short-term rates over the remaining lifetime of the long term contract.
In conclusion, the economic statements from the officials of Federal Reserves have greater effects on the short-term interest rates as compared to longer rates since they have a bearing on the economic course and monetary policy over a shorter durations. However, the effects of long-term interest rates may be considerable because it has clear implications for the expected course of the short-term rates over a longer period.
References
Capistran, C. (2016). Bias in Federal Reserve Inflation Forecasts: Is the Federal Reserve Irrational or Just Cautious? SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.648623
Dudley, W. (2016). Federal Reserve Bank of New York. The U.S Economic Outlook and Implications for Monetary Policy.
FRB: Federal Open Market Committee. (2016). Federalreserve.gov. Retrieved 24 March 2016, from http://www.federalreserve.gov/monetarypolicy/fomc.htm
Grey, G. (2002). Federal Reserve System: Background, Analyses and Bibliography. Nova Publishers.
Keefe, T. (2013). How Much Influence Does The Fed Have? | Investopedia. Investopedia. Retrieved 24 March 2016, from http://www.investopedia.com/articles/stocks/08/monetary-policy.asp
