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Complexities of the U.S. Financial System, Research Paper Example

Pages: 3

Words: 934

Research Paper

The U.S. is the world’s largest economy and its financial system is arguably the most advanced in the world and one of the major factors behind the competitiveness of the U.S. economy. First of all, the U.S. financial markets ensure the smooth flow of funds from individuals and companies look to invest or earn interest on their funds to individuals and companies seeking funds for their consumption and investment activities (Federal Reserve Bank of San Francisco, 2005). Thus, the U.S. financial markets assist towards efficient allocation of resources towards their most productive uses which helps the economy grow. This also helps raise the standards of livings as workers earn more on the average and also spend more. Their consumption activities influence companies to further expand their scale of operations. Without an efficient U.S. financial system, not only will access to funds be difficult and expensive but there will also be higher unemployment rates. When the economy expands, it also means higher tax revenues for the government as well as greater spending on public welfare programs including transportation and communication infrastructure and education. Similarly, U.S. financial markets also help attract foreign direct investment (FDI) because international companies gain access to funds at lower costs than in other less developed financial markets. This also adds more liquidity to the system.

The Federal Reserve could be understood as an independent government body, subject to oversight from the Congress, that studies and implements the country’s monetary policy. Fed is led by a chairman which is currently Ben Bernanke who succeeded Alan Greenspan on February 1, 2006. In addition to the chairman and vice chairman, the affairs of the agency are also managed by a Board of Governors, consisting of seven members, each of whom serves 14 year terms. The Board of Governors also supervises 12 regional Federal Reserve Banks around the country. The policy making branch of Fed is Federal Open Market Committee (FOMC) which makes important decisions regarding interest rates and other monetary policies (Investopedia). The importance of Fed has once again become clear during the recent financial crisis. The Fed has been keeping interest rate low for quite some time (Reuters, 2013) which may be the reason why U.S. has fared better than many European countries in terms of economic recovery. When interest rates are low, individuals and businesses are encouraged to borrow for the purpose of personal consumption and investment activities. The result is higher spending levels as well as quicker recovery. The effectiveness of Fed’s policies has even been supported by IMF which claims Europe is falling behind the U.S. in terms of recovery from the recent financial crisis because the interest rates in many European countries are still higher than what is required to achieve growth (EU Observer, 2013).

Interest rates have different impact on the U.S. and global financial environment. When interest rates are lower in the U.S., more consumers and businesses borrow for consumption and investment activities for the simple reason that it is cheaper to borrow. This helps increase economic activity and the result is positive economic growth. Higher interest rates have the reverse impact and lower demand by consumers may even force businesses to lay-off workers which means not only unemployment rate increases but the demand for goods and services also declines further. But there is always a danger that keeping interest rates low for too long may boost demand for goods and services to such a great extent that the result will be high inflation rate (Investopedia, 2011). Interest rates also affect global financial environment as higher interest rates attract foreign capital into the country in search of higher returns and lower interest rate does the reverse which in turn affects the country’s currency value as well. Higher interest rate results in currency appreciation because there is greater demand from foreign investors and vice verse. The currency depreciation is not necessarily a bad thing because it makes the country’s exports more competitive since it is cheaper for foreign consumers to buy American products due to cheaper U.S. dollar. Similarly, currency appreciation may put U.S. exports at a disadvantage against its international trading partners.

Companies also take into account exchange rates when deciding whether to operate in a foreign market or not. Exchange rates affect the profitability of companies’ overseas operations because profits brought back to the country have to be converted into U.S. dollar. Thus, the appreciation of U.S. dollar may mean that the profits would be lower when converted to dollar and higher in case of depreciation of dollar. The above example assumed a scenario in which a U.S. corporation has a foreign subsidiary. If an American corporation merely exports, the exchange rate may affect its profit margins in international markets. If U.S. dollar depreciates, the U.S. exporter may have to charge higher prices in international markets to protect profit margins and a significant depreciation may put the U.S. company at a disadvantage against foreign competition. Similarly, companies may be force to adopt exchange rate management policies when exchange rates are highly volatile to reduce uncertainty and risk.

References

EU Observer. (2013, April 17). IMF warns Europe of falling behind US on recovery. Retrieved July 27, 2013, from http://euobserver.com/economic/119829

Federal Reserve Bank of San Francisco. (2005, January). Please explain how financial markets may affect economic performance. Retrieved July 27, 2013, from http://www.frbsf.org/education/publications/doctor-econ/2005/january/financial-markets-economic-performance

Investopedia. (2011, September 6). How Interest Rates Affect The U.S. Markets. Retrieved July 27, 2013, from http://www.investopedia.com/articles/stocks/09/how-interest-rates-affect-markets.asp

Investopedia. (n.d.). The Federal Reserve: What Is The Fed? Retrieved July 27, 2013, from http://www.investopedia.com/university/thefed/fed1.asp

Reuters. (2013, July 26). Dollar falls as Fed seen keeping U.S. rates low for some time. Retrieved July 27, 2013, from http://www.reuters.com/article/2013/07/26/us-markets-forex-idUSBRE96K0DS20130726

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