Discount Rate and Monetary Policy, Research Paper Example

The factors that may influence the Federal Reserve in adjusting the discount rate include inflation (U.S. Department of State) and economic growth rate. If the inflation rate is high, the Federal Reserve may increase the discount rate which is a rate at which the commercial banks may borrow from the Federal Reserve. When the discount rate goes up, it becomes more expensive for the companies and individual citizens to borrow money from the bank. This results in a reduction in money supply because companies and individuals cancel or delay their spending and consumption plans. Thus, a lower demand for money may help bring down the inflation rate. Similarly, when the economic growth rate is negative or low, the Federal Reserve may lower the discount rate. This will also lower the rate at which the companies and the individuals may borrow from the bank. Low rates will encourage consumption and spending activities within the economy, thus, giving a boost to the economic growth rate. Similarly, if Fed feels that the economy is heating up and growing too fast, it may increase the discount rate to lower money supply.

The discount rate has a direct relationship with the specific interest rates set by the bank. When the discount rate is low, banks also set their specific interest rates low and are more generous with extending credit to companies and individual lenders. Banks may even loosen up their loan qualification criteria in addition to earn profit through volume lending. We have seen the examples last decade when banks started extending credit to even high credit risk individuals because the interest rates were quite low. On the other hand, higher discount rates mean the banks will also tighten their lending activities and will not only provide funds to only some of the applicants but will also be less generous in credit terms.

In the short term, there is a trade-off between low unemployment and high inflation rate. Monetary policy attempts to ensure that the interest rates do not remain low for so long that the resulting aggregate demand exceeds the economy’s long term production capacity. If the interest rates remain low for too long, people and the markets will develop expectations for high inflation rate in the future and will start demanding bigger increases in wages. Thus, the Fed’s objective is to lower interest rate to a level where it could stimulate spending and consumption activities within the economy but do not keep the interest rates low for longer than necessary. Once the economy has recovered and economic objectives have met, Fed should raise the interest rates so as to avoid economic overheating and inflation (Federal Reserve Bank of San Francisco).

The monetary policy could affect the money supply in three ways which are purchasing or selling securities in the market, lowering or raising the federal discount rate and lowering or raising the reserve requirements. If the Fed wants to increase the money supply, it will purchase the securities in the market, lower the federal discount, rate and lower the reserve requirement and vice versa. When the Fed purchases the security, it increases the money supply. Similarly, when it lowers discount rate, it is easier for the commercial banks to borrow and they also respond by increasing credit supply to businesses and individual consumers. Similarly, lowering the reserve requirement means banks have more money which could be loaned out.

A stimulus program significantly increases the money supply. A stimulus program creates job in the public sector and also provides incentive to private sector to make capital investments and hire workers. Higher number of jobs means more people are earning money and some of that money is deposited in the bank. Banks loan that money to other customers which in turn will spend some and deposit the rest and the cycle continues. The money supply will also increase because stimulus programs may be accompanied by lower reserve requirements which means the bank would need to keep a lower percentage with them and could loan out the rest. Similarly, the borrowing by both the businesses and the individual consumers will increase and some of the borrowed money will be deposited and create another cycle of money creation.

The recent economic indicators show that U.S. money supply has been increasing which should not be surprising. As of October 2011, the money supply as measured in terms of M2 had grown by 10% over the previous twelve months (GoldMoney, 2011). First of all, the U.S. is still trying to fully recover from the recent financial crisis. Thus, one can expect Fed to keep interest rates low in order to encourage borrowing by both the businesses and the individual consumers and this is exactly what has been happening. The Fed has been keeping interest rates unchanged for quite a while now because the economic recovery has been slower than expectations. Some even fear that the Fed’s current policy may lead to inflation but the Fed has not yet indicated any desire to raise the interest rates. In addition, the U.S. government has also been engaging in stimulus spending to create jobs in the public sector and encourage private sectors to make capital investments. Even though the job market data is still mixed, the unemployment rate has declined though not as much as the government would have liked. Thus, newly employed workers have also been contributing towards money supply growth through both spending and bank deposits. Even though money supply has increased, it is still not too much because the Fed doesn’t see any immediate threat of inflation, thus, it has been leaving its policy of low interest rates unchanged.

References

Federal Reserve Bank of San Francisco. (n.d.). About the Fed. Retrieved May 20, 2012, from http://www.frbsf.org/publications/federalreserve/monetary/affect.html

GoldMoney. (2011, October 22). US money supply growing fast. Retrieved May 20, 2012, from http://www.goldmoney.com/gold-research/us-money-supply-growing-fast.html

U.S. Department of State. (n.d.). Bank Reserves and the Discount Rate. Retrieved May 20, 2012, from Bank Reserves and the Discount Rate