The Federal Reserve Research Paper

Unlike most countries, that use the central Bank system the U.S has a federal Banking system which is also known as the fed. The headquarters of the federal Bank is in the capital Washington D.C and also has other twelve district banks in different locations. Decisions made by the Federal Reserve Bank are critical because they ensure that the country has a safe and sound financial system. Federal Reserve Act established the fed in 1913 and was formed to solve problems of money in the country. Therefore, the Federal Reserve Bank is mandated to formulate the best fiscal and monetary policies for the economy to be stable. The Federal Reserve System was established with 12 regional Banks to meet the needs of the country’s complex and large economy by decentralizing its functions to the regions.
Federal Reserve Bank, together with its twelve branches acts as a financial and fiscal agent on behalf of the national government. The central functions of the Federal Reserve Bank are to create a sound financial system for the country and protect its citizens from inflationary pressures. The Federal Reserve BANK has six functions; control of the money supply is the objective of any central Bank. The fed is mandated to prevent the occurrence of an increase in interest rate that has a negative effect on the economy. Supply of currency brings price stability in the economy hence inflationary tendencies that can cause a slow growth to the economy.
Supply of currency is made through printing of currencies and releasing it to the economy and to reduce supply is made by mopping up the currency supply to ensure that there is price stability. Holding Bank reserves is another function of the Federal Reserve Bank. Keeping an account with the federal Bank is mandatory and it ensures that there is an optimum supply of money in the economy. Commercial banks are supposed to keep a set threshold of reserve in these accounts whish are in the Federal Reserve Bank. Another role of the fed is to supervise commercial Banks. Without seeking any permission, the fed can check books of the Bank to determine how accurate they are and whether they follow Banks regulations. It is another way to ensure that monetary policy is effective with an aim of stabilizing the economy.
The Federal Reserve Bank receives its resources from the interest on securities that the government has acquired through open market operations, investment in foreign currency and charges on services provided to commercial Banks and other depository institutions. For this reason, the Federal Reserve Bank can act independently without the influence of the national government. To encourage growth in the economy, the reserve bank introduces expansionary monetary policies such as reducing interest rate to increase private investment because investors may take up more loans.
There are two types of tools that the federal bank uses to manipulate the economy and that are monetary and fiscal policies. Aggregate demand management is done through the monetary policy in which the fed influences cost of credit and money as well as influencing the availability of the currency to reach the goals of price stability and full and sustainable employment. Targeting the overnight inert bank lending rate is the most effective tool in monetary policy and this is done through open market operations and the purchase and sale of securities. The main aim of open market operation is to make interest rates stabilize, there are three categories of operations that open market operations works under and these are fine tuning operations, main business operations, and structural operations. Repurchase agreement is a process in which the fed mops up excess liquidity in the market.
Standing facilities is the second instrument under monetary policy tool. These are facilities available that are available to commercial banks without any restrictions. They include overnight deposits and overnight loans that help in mopping up excess liquidity in the economy. The third tool is a minimum reserve that serves as a tool of mopping up liquidity. The fed puts minimum percentage in which the commercial banks should place with the Federal Reserve Bank. This increase or decrease is determined according to the liquidity in the market. Increasing the minimum reserve ratio reduces the amount extra currency in the market while reducing the reserve ratio reduces the minimum reserve ratio ensures that the currency supply is increased. Intervention of foreign exchange market is another method or instrument that the Federal Reserve Bank can use to stabilize the market.
Fiscal policy is the second tool that the federal government uses to create full employment and stability in the business. Tools of fiscal policy include changing of government spending, making effective changes in taxation and the automatic stabilizers. Changes in government spending are considered as the most effective tool under fiscal policy tool because it takes a short time to create the necessary changes needed in the economy. Government increases its appending to encourage economic growth in the country by putting more money in the different departments such as increasing spending on defense, health and education among others. On the other hand, the government through policies formulated by the Federal Reserve Bank reduces the spending in different departments to reduce the amount of currency in the market.
The second instrument used under fiscal policy tool is taxation changes. Fed changes the rates of taxes of corporate, personal taxes, sales and exercise taxes to increase or reduce the amount of currency in the market. There are two types of fiscal policies and these are expansionary and contractionary fiscal policy. When the economy is on a recession and the government wants the aggregate demand to rise, therefore, cut the taxes to increase the disposable income hence creating growth in the economy. On the reverse, contractionary fiscal policy is when taxes are increased to personal and corporate incomes when there is inflation in the economy. It in turn causes the reduction of the amount of money in the economy, therefore, reducing the disposable income. Reducing government spending also falls under contractionary fiscal policy.
All these are steps that the Federal Reserve Bank takes to either reduce or increase the amount of circulation in the economy. An economic indicator is data of macro-economic scale that is used by the Federal Reserve Bank to judge and interpret the health of the economy. The data can also be used by investors to judge the future performance of the economy. The economic indicators that the Federal Reserve Bank include; consumer price index, unemployment rates and figures, the rate or value of crude oil and, therefore, the gross national product of the country.
Economic indicators enable the Federal Reserve Bank to know the different monetary or fiscal tools to use to rectify the economy. The first economic indicator that the Federal Reserve is the gross domestic product; based on this parameter the various tools that are monetary or fiscal are used. The gross domestic product of an economy reduces means that the economy is growing at a slow rate. The fed can, therefore, use monetary policy to increase growth and, therefore, the gross domestic product. One of the monetary instruments is increasing government spending, reducing the minimum reserve ratio of commercial banks and allowing banks to lend more by reducing the base rate. By doing these, the fed increases the disposable income of the people to spur economic growth, therefore, increasing the country’s gross domestic product and vice versa.
The second economic indicator that the Federal Reserve Bank uses is the unemployment figures. The optimal unemployment rate of a country according economic analysts is below 5% that means that anything above this figure is considered a high unemployment rate. The Federal Reserve Bank should use monetary policies to increase government spending and reduce minimum reserve rates of commercial banks to increase the money supply to the optimum level of unemployment. Fiscal policies used are increasing government spending on infrastructure and other regular government budgets and also cut the tax rates on personal and corporate incomes.
Consumer price index is another indicator used by the Federal Reserve Bank to know the monetary or fiscal instrument in order to change the economy. The other name for consumer price index is inflation; it shows the amount of money needed to purchase a basket of goods or services. The price changes associated with increase or decrease of the cost of living. The best measure used by the Federal Reserve Bank to restore normalcy to the economy fall under both monetary and fiscal policies. Mopping up extra liquidity in the economy is the most appropriate measure hence base rate should be increased by the committee that sets the base rate. Subsequently, commercial banks shall increase the rate of lending and many people avoid taking up loans. On the other hand, fiscal policy shall ensure that the government reduces its expenditure and tax rates are increased to mop up excess liquidity.
The price of crude oil is the fourth economic indicator that the Federal Reserve Bank uses when it wants to implement the monetary or fiscal policies. The increase or decrease of crude oil prices affects the cost of living either by rise or fall. Increasing in prices of crude oil is countered by cutting the supply of money in the market. Therefore governments spending reduction, tax increase and increase in lending by banks are some of the monetary and fiscal policies that can be used by the Federal Reserve Bank to create stability of the economy in the country.
Monetary policy works best when implemented in a complementary way with the fiscal policy. However economist and the other monetarist argue that the way to influence the economy is by change in interest rate and money supply. Fundamentally monetary policy is based on the idea that printing more money, reducing bank interest rate, lending more money and discouraging savings by the people shall expand the economy and vice versa. Monetary policy has advantages as compared to fiscal policy, one, is that inflationary pressures tend to be created by fiscal policies. Spending by government is more likely to cause inflation. It is, therefore, difficult for a cut in spending and increase taxes because its reputation rate and ratings can plunge hence fiscal policy has never been very effective.
Another reason monetary policy holds an advantage over fiscal policy is because of the speed of results. Fiscal policy is slowly enacted because the congress must be debated and take months for it to be put into law while monetary policy is often under the hands of economists. Politics influences many decisions when it comes to fiscal policy implementation, therefore, it is not an effective way of creating change in the economy. However, in a recession monetary policy may not be that effective and this is one of the weaknesses of monetary policy. It can be remembered that in 2009 during the recession period there was a liquidity trap where cuts in the interest rate were not sufficient to spur investment and encourage spending. This was as a result of insufficient credit in banks.
Depending on the bank, there are many operations of banks. However the central operation of a bank is providing loan services to its customers and also mortgages and investments. The amount of loans that are dependent on the standard rate set by the Federal Reserve Bank. Commercial banks are regulated mainly by the Federal Reserve Bank that is mandated to ensure that commercial banks comply with various rules that are set by the fed. There are also other primary regulators of the commercial banks and these are the federal deposit insurance corporation, state regulators and the office of the comptroller of the currency. All these agencies ensure that the consumers’ rights are being protected.
Under the Federal Reserve, banks are complied to follow set rules and regulation. Failure to follow these set rules, the federal government is forced to intervene and make the said banks make the corrections by offering assistance if necessary. The federal government ensures that the market in which the banks operates is balanced by regulating the rate at which banking organization are acquired so as to balance between the suppliers and the consumers.
According to the monetary policy, the economy usually goes through a time in which there is a boom or growth, and this is usually accompanied by another time in which the economy slumps down or it slows down. This growth and slowing down time vary in length and their impacts are very different and this is commonly known to as the business cycle. With the monetary policy, the boom time is usually accompanied by the banks giving out loans to consumers so that they can do business. In the recession period, the banks decrease giving out loans since the conditions are not favorable. The relationship that money has with the business cycle is a major factor that shows growth in the economy is primarily determined by the monetarist policy.
Therefore, this determines the growth in employment in the economy, level of income growth of the consumers, and also the level of the inflation rate that the economy experiences. The monetarist usually looks at the level of monetary growth as an indicator of the impact in which the monetary policy has on the economy. The Federal Reserve, therefore, has an entitlement to make sure that there’s a steady growth in the money supply so as to maintain the business cycle at a desired level of economic growth.