The principal purpose of the Federal Reserve System, known as the Federal Reserve, is to guarantee maximum employment, even prices and reasonable long-term interest rates. Congress, while retaining oversight, has entrusted this responsibility to the Federal Reserve. Created largely as a result of several financial panics around the turn of the century, the Federal Reserve System was fashioned with the passing of the Federal Reserve Act on December 23, 1913. As a result of the Act and subsequent amendments, the Federal Reserve conducts the United States monetary policy, regulates banks and guards the credit rights of consumers. Additionally, The Federal Reserve is responsibility for sustaining the stability of the U.S. financial system and providing financial services to the government. In addition to loaning money to commercial banks, the Federal Reserve also issues Federal Reserve notes that comprise the American paper money system. A seven-member Board of Governors is appointed by the President of the United States to serve a fourteen-year term. This board controls the operations of the twelve Federal Reserve banks and thousands of member banks that are scattered across the country. The twelve Federal Reserve banks are often called the central banks. The Board of Governors determines how much money member banks must set aside to maintain solvency. They also determine the discount interest rate, Federal Funds rate and to what extent the central bank charges the member banks (Koning, 2010).
The monetary policy implementation by the Federal Reserve can be defined as the actions the Board of Governors take to manipulate the cost of money, reserve claims for unemployment and stabilize commodity prices. The actions and policies of the Federal Reserve influence consumers’ purchasing powers and businesses revenue forecasts. In times of financial crisis, the central bank can lend money as a last resort in order to keep the financial system solvent (Labonte, 2013, p. 2). During the recent financial crisis, the Federal Reserve took several measures in an effort to stabilize the economy. This paper examines these measures and others that can be taken in the current economy.
The Role and the Effectiveness of the Federal Reserve in Stabilizing the Current Economy
Before the credit crunch in 2007, most economists believed that small changes to the federal funds rates could maintain a stable business cycle. As the financial crisis got worse, the Federal Reserve took unusual and unparalleled actions to re-establish financial stability. Unemployment rate continued to rise until mid-2003, as the United States economy was rebounding from a small recession in 2001. The Federal Reserve was worried that the economy would slide into recession so they kept the federal funds rate very low. The rate reached 1 percent by mid-2003 (Labonte, 2013, p. 9). As the economy began to expand and prices began to increase, the federal funds rate was increased to 5 1/4 percent by mid-2006. According to Labonte:
It is now argued by some economists that the financial crisis was, at least in part, due to Federal Reserve policy to ensure that the then-ongoing expansion continued. In particular, critics now claim that the low short-term rates were kept too low for too long after the 2001 recession had ended, and this caused an increased demand for housing that resulted in a ‘price bubble’ (Labonte, 2013, p. 9).
The economy was more and more susceptible to changes in short-term interest rates largely due to the move to floating interest rate mortgages from fixed interest rate financing for housing. The Chairman of the Federal Reserve Benjamin Bernanke stated that the low home mortgage rates were largely caused by a glut in global savings. Bernanke went on the say that the Federal Reserve had little control over these savings due to constraints in the regulatory framework. The Federal Reserve’s later policy of tightening monetary policy was to burst the ‘housing bubble,’ claim critics. The critics further suggest that lax lending standards, which were regulated by the Federal Reserve, also contributed to the crisis. The subsequent increase in bank leverage ratios meant that they could borrow more overnight and create collateralized debt obligation(sub prime loans) in the securitization chain.
When the ‘housing bubble’ burst, it led to a financial crisis that not only affected banks selling sub-prime loans but other business involved with real estate development. Financial institution experienced major losses as record numbers of people defaulted on their mortgages. In late 2007, the United States economy entered a recession, with global repercussions. This caused a liquidity problem with the banks and other types of loans were soon adversely affected. An example of such a bank is Bear and Stearns which ran out of cash and was later acquired by JP Morgan & Chase for two dollars a share backed thirty billion dollars in Federal Reserve emergencies. It became more difficult for consumers and business to borrow money and other industry were greatly affected so the Federal Reserve had to pump more cash into the economy to keep things running. It also had to takeover major mortgage firms that had filed for bankruptcy in order to revive them as a statutory requirement. When the extent of the financial crisis became obvious and in an effort to stabilize the economy, the Federal Reserve responded by lowering the federal funds rate from 5 1/4 percent to 0 percent to 1/4 percent (Labonte, 2013, p. 9). There are many indicators used by the Federal Reserve to analyze the performance of the economy.
Economic Indicators the Federal Reserve Should Analyze So It Can Better Stabilize This Particular Economy
In the investment world, there are a number of economic indicators that are closely watched. The Federal Reserve watches many of these economic indicators because it aids them to determine what federal fund rate level to set. The Federal Reserve must monitor and analyze these indicators in order to best formulate their policies. These indicators include:
Gross Domestic Product – One of the most important indicators is the Gross Domestic Product report. It is the monetary value of all products and services created by the whole economy in a quarter of a year. It is the widest gauge of the condition of most economies. The Federal Reserve focuses on the growth rate of the Gross Domestic Product. A quarterly growth rate of the American economy between 2.5 to 3 percent per year is usually considered optimally good. Growth below this level typically means that the economy is pessimistic; unemployment rate increases marginally and there is reduced consumer spending due to erosion of purchasing power. Growth above this level can lead to inflation.
Consumer Price Index – The Consumer Price Index is a measurement of inflation. It gauges the increase or decrease in the cost of a group of consumer goods and services. This group comprises of approximately 200 kinds of goods and many these products range from foods stuff and energy to more ostentatious consumer goods.
The Producer Price Index – The Producer Price Index is way to measure inflation. It measures wholesale price of goods. The price indicator for this index obviously has to be lower than the retail price.
Retail Sales Index – The Retail Sales Index gauges goods sold by the retail sector, from large chain store to small local stores. The index comes from a sampling of stores across the U.S. and is released on the 12th of each month at 8:30 am east standard time. It indicates consumer confidence and the general health of the economy.
The National Association of Purchasing Management Index – This index measures the expansion (growth above 50%) or contraction (index value below 50%) in the manufacturing sector. It is uses a survey of approximately 250 companies within numerous industries across the United States. This index is released on the first business day of each month as a way of reporting progress in business functions such as new orders, inventory levels, exports and imports.
Consumer Confidence Index – Considered an important indicator of the overall economic picture; it measures the confidence of consumers in household purchasing by sampling about 5,000 households.
Beige Book – The Beige Book is a synopsis of economic circumstances in each of the Federal Reserve’s twelve regions (districts). It is published eight times in a year and involves interviewing key economist, bank directors and market analyst prior to FOMC (Federal Open Market Committee) meetings.
Durable Goods Orders – The Durable Goods Orders information gauges the amount of money consumers are spending on long-term items. The order shows whether a factory will be busy in the near future producing durable goods. Advanced reports for durable goods and manufacturers’ shipment, inventory and orders help investors recognize trend in economic growth.
Employment Cost Index – This is another important indicator of inflation, the index shows the cost of labor, to include wages, benefits and bonuses. As wages increases so does the inflation rate, because on the other hand it is not uncommon for compensation to increase as companies begin to elevate the prices
The Productivity Report – The Productivity Report measures the amount of output a unit of labor produces in a defined time frame.
All of these indicators provide the Federal Reserve Board of Governors with the means of analyzing the economy. No one indicator provides a clear enough picture of the current economic condition. Together, they assist the Federal Reserve to better stabilize the current economy through the adjustment of the federal funds interest rate (Leading 2013). One way to stabilize the economy is through increasing the money supply.
Monetary Policies the Federal Reserve Might Use To Influence the Money Supply
There are several instruments that the Federal Reserve has used to conduct monetary policy. Each instrument affects the size of the monetary reserves available to depository financial institutions. The institutions are required to maintain reserves against the amount of money deposited by retail and corporate clients, such as checking accounts, savings accounts or certificates of deposit. The reserves can be held in the bank’s vault or by depositing the cash in one of the Federal Reserve banks. The sizes of the amount of deposits relative to the amount of assets the financial institution can acquire are set by the Federal Reserve. These assets are often referred to as credits as they may form loans made to consumers and businesses (Labonte, 2013, p. 3).
There are three ways in which the Federal Reserve can expand or reduce the supply of money and credit. The main way is called open market operations. In this method, the Federal Reserve buys existing United States Treasury bonds and bills or securities that have already been bought and sold privately. It purchases these with newly issued Federal Reserve Notes. This increases the amount of reserve base and allows lending institutions to make more loans and increase credit since their leverage ratio is improved. The reverse is true if they sell securities. The second method is for the Federal Reserve to change the reserve requirements by managing the amount of deposits a financial institution must hold in their vault or on deposit with the Federal Reserve Bank. This affects available capital in the market for loans. In later 2008, the Federal Reserve started to pay interest on the required and excess reserves. This reduced the cost of holding the money versus lending it out. The third method of influencing the money supply is through permitting certain financial institutions to borrow from the Federal Reserve Bank on a temporary basis. They are charged a discount rate which is lightly higher than the federal funds rate to check default risks. These transactions are usually on an overnight basis. This method was an important source of reserves for many institutions during the recent financial crisis (Labonte, 2013, p. 3).
Strengths and Weaknesses of Using Monetary Policy In Comparison To Fiscal Policy When Promoting Economic Activity and Preserving Price Stability
There are significant differences between fiscal policies and monetary policies. The United States Congress is responsible formulating and implementing fiscal policies while the Federal Reserve is responsible formulating and implementing monetary policy. The Federal Reserve operates the Central Bank, thus controlling the nation’s money supply. The economy is affected in more ways than supply and demand. Both fiscal policy of the government and the monetary policy of the Federal Reserve contribute to the overall economy. Each has the potential to affect the economy. Both have advantages and disadvantages. For example, the Federal Reserve can be more effective in slowing down the economy in order to promote more employment and slow down inflation with its monetary policies by setting a base interest rate. The government must raise taxes or reduce spending in order to slow down the economy. Neither of these actions is politically popular.
The Federal Reserve can also increase interest rates which will deter people and businesses from borrowing money hence slowing down growth. In this example, the monetary policy of the Federal Reserve is more effective than that of the government’s fiscal policy of keeping interest rates fixed. Another advantage the Federal Reserve has over the government is its independence. Fiscal policy has to be created on a democratically and politically transparent process which usually involves a lot financial lobbying and consultation. The Federal Reserve on the contrary can act more rapidly without the time consuming process that fiscal policy formulation follow.
Fiscal policy can be more effective in fostering economic growth by increasing Government spending and lowering taxes. In this example, fiscal policy can be more effective than monetary policy. While the Federal Reserve will use monetary policy to promote growth, banks may be reluctant to lend at low interest rates and businesses may be reluctant to invest in recessionary times. Consumers may be reluctant to borrow, unsure about long-term economic conditions. It follows that monetary policy will probably not promote growth in times of recession while fiscal policy has a greater chance in creating improvement in such times. Monetary policy works to slow the economy in times of rapid expansion while fiscal policy works to grow the economy. Both policies have the ability to promote economic activity and preserving price stability in their own ways. Probably the action that affects aggregate demand most is the Federal Reserve movement of interest rates (Kiley, 2012, p. 1).
Effect of the Federal Reserve’s Actions on the Aggregate Demand/Supply Model
The predominant thinking in macroeconomics is that short-term interest rates are central to aggregate demand. However both long-term and short-term interest rates are keys to spending and investment decisions. The most important factor influencing aggregate demand in the United States economy is interest rates (Woodford, 2003, p. 669). The Federal Reserve determines the federal funds rate at a level it thinks will promote financial and monetary optimal activity consistent with attaining its monetary policy objectives. The decrease in interest rate from 6.5% to 1.75% in 2002 was unexpected after the federal economic stimulus. For the U.S, we can predict an outward shift in aggregate supply to correspond to a 3.0% annual rate of growth in potential output or production in different economic sectors. It adjusts federal funds rate based on evolving economic developments. Any variation in the federal funds rate can affect stock prices, foreign exchange rates and short-term interest rates. Differences in either fiscal or monetary policy can be anticipated to have little impact on the rate of change of aggregate supply in the short run. Consequently, the focus of macroeconomics is to comprehend the impact of macroeconomic policies on aggregate demand, where changes in aggregate demand affect the economy’s inflation and unemployment rates. Changes in these factors can affect consumer and business spending decisions. When interest rates are high, people tend to invest in interest-bearing bonds and economize on their other money holdings. As a result, the amount of aggregate demand is less (Purposes, 2005, p. 16).
If the economy slows and unemployment increases, the Federal Reserve is inclined to ease monetary policy to stimulate aggregate demand. When aggregate demand in increased and the economy begins to grow, unemployment will decrease and the economy will return to a more favorable path. The growth of potential output is reflected in the outward expansion of the production possibilities frontier. As you may recall, essential factors causing growth in the production possibilities frontier are increases in resources (e.g., the labor supply) and changes in technology. The aggregate supply should be assumed to remain constant in the near future though with incorporation of computers in production process in the long run will enhance productivity. If the economy shows signs of growing too fast and inflation increases, the Federal Reserve will tighten monetary policies to force aggregate demand below the potential of the economy to produce. They will keep these policies in place for as long as necessary in order to relieve inflationary pressures and to return the economy to a more favorable path (18).
This paper examined the measures taken and the actions they can be taken by the Federal Reserve stabilize the current economy. The Federal Reserve has done several things. They can do much more to affect the current United States economy. They can adjust the federal funds rate or they can purchase more securities or require banks to have more reserves. They can also permit more short-term borrowing. However, the current conditions may not lend themselves to actions by the Federal Reserve. Federal Reserve Chairman Ben Bernanke stated recently that he thinks the current American unemployment is due largely to lack of economic demand:
Is the current high level of long-term unemployment primarily the result of cyclical factors, such as insufficient aggregate demand, or of structural changes, such as a worsening mismatch between workers’ skills and employers’ requirements? … I will argue today that, while both cyclical and structural forces have doubtless contributed to the increase in long-term unemployment, the continued weakness in aggregate demand is likely the predominant factor (Demand, 2012).
Monitoring of key economic indicators and monetary policies by the Federal Reserve performed in concert with fiscal policies of the United States government maybe the best means to strength the current economy.
Demand, not supply, is restraining the economy. (2012). CBS Money Watch. Accessible at: http://www.cbsnews.com/8301-505123_162-57405230/demand-not-supply-is-restraining-the-economy/.
Kiley, Michael T. (2012). The Aggregate Demand Eﬀects of Short- and Long-Term Interest Rates. Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Aﬀairs. Washington D.C.: Federal Reserve Publications Department.
Koning, John Paul. (2010). A Visual History of the Federal Reserve System 1914 – 2009. Accessible at http://www.financialgraphart.com/fedchart.html.
Labonte, Marc. (2013). Monetary Policy and the Federal Reserve: Current Policy and Conditions. Publication No. RL30354. Washington D.C.: Congressional Research Service.
Leading Economic Indicators Explained. (2013). Investor Guide. Accessible at http://www.investorguide.com/article/11599/leading-economic-indicators-explained-igu/.
Purposes and Functions. The Federal Reserve System. (2005). Washington D.C.: Federal Reserve Publications Department.
Woodford, Michael. (2003). Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton: Princeton University Press.