Federal Reserve Term Paper Examples

Abstract

This paper is aimed at answering five major questions as provided by the instructor. The questions are related to the Federal Reserve and its role in affecting the economy of the country. The first question is related to evaluating the role as well as the effectiveness of the Federal Reserve in stabilizing the current economy. The second question pertains to determining the economic indicators the Federal Reserve should analyze in order to better stabilize this particular economy. The third question is about describing which monetary policies the Federal Reserve might use to influence the money supply. In the answer to the fourth question an attempt has been made to explain the strengths and weaknesses of using monetary policy in comparison to fiscal policy when promoting economic activity and preserving price stability. The last question is linked with analyzing the effect of the Federal Reserve’s action that have been identified in the question #3 on the aggregate demand / supply model.

Introduction

Economic growth and stability highly depends on the monetary policy formulated by the central bank like Federal Reserve. The market for balances held at Federal Reserve play vital role in determining the various aspects of monetary policy. The financial depository institutions keep their accounts with reserve banks which held balances in trade among these accounts at the federal interest rate in federal funds market.

Evaluating the role and the effectiveness of the Federal Reserve in stabilizing the current economy

The federal interest rate is controlled considerably by the Federal Reserve. This control is exercised through influencing the supply and demand of balances at reserve banks level. Stock prices are greatly affected by changes in the long term interest rates. The stock prices also affect the household wealth. Investors always put their efforts in the direction to keep investment revenues of stocks in accordance with the returns gained on their bonds. They also allow some higher degree of risk on the stocks in such cases.
In case if the long term interest rates are lowered then it would result in exceeding the returns on stocks as compared to bonds which would result in buying of stocks by investors. The buying of stocks would be balanced with bonds once the stock price rise to such a level that the expected risks on return on it would result the same as equal priced bonds.
This is also affected by the perception of the investor that lower interest rate will result in economic strength and profits on stocks would be higher in future. This would also result in raising of equity prices of stocks. Stabilizing economy is done by Federal Reserve through controlling long term as well as short term interest rates .
Any changes in monetary policy result in varying the exchange value of USD in comparison to other currencies. For instance, a rise in interest rate by Federal Reserve in the monetary policy would attract international investors to invest in USD assets. This would result in raising the value of USD in international markets through higher level of bidding by the investors. The high value of USD will result in decreasing cost of imports while increasing price of exports. The scenario reverses in the situation where Federal Reserve decreases interest rates .

Economic indicators the Federal Reserve should analyze

Federal Reserve should analyze following major economic factors to stabilize the economy:-
1. Real GDP (Gross Domestic Product)
Real GDP is an important economic indicator. Federal Reserve should always consider the real GDP or Gross Domestic Product data before taking any decision in formulating new monetary policy. Real GDP shows a good picture of the economic condition. The adjustments in monetary policy need to be given due deliberation in light of real GDP .
2. Money Supply
The money supply does not consist of monetary fund assets of financial institution or large denominated time deposits. It also does not include the reserves specially held by banks that are required to be retained. Money supply data should be analyzed by assessing the financial and economic conditions in order to get help in changing the monetary policy. The major changes in monetary policy as made as the result of analyzing money supply are either lowering or raising of interest rates.
Federal Reserve may either want to increase or decrease money supply depending on the accessed money supply indicators. Economic recessions as well as recoveries from them are also predicted by economists and other financial experts through analyzing the data obtained for money supply. The stock price variations are also result of money supply hence Federal Reserve should give due consideration to money supply in order to stabilize the economy.
3. Consumer Price Index
The Consumer Price Index is simply known as CPI and it does not necessarily an indicator for each and every product bought by all the consumers. It is the reflection of samples taken for few hundreds of services and goods from a line of 200 categories of items. The information for this indicator is collected through personal visits as well as phone calls in more than 80 urban regions throughout the country.
The Federal Reserve needs to consider the CPI data while formulating a new monetary policy since this indicator tells about the buying pattern as well as trends in consumer goods and services. Federal Reserve would need to balance out sales of various commodities in order to stabilize the economy.
CPI does not reflect taxes on social security, income level, and investments especially in stocks, bonds and life insurance. CPI includes all the sales tax related to buying of the services as well as goods. CPI is the best indicator of inflation in economy. Inflation is highly associated with economic stability hence Federal Reserve should include CPI as a key economic indicator in formulation of a new monetary policy for economic stability.
4. Producer Price Index
The Producer Price Index or simply the PPI indicates any change in price almost in all the sectors that are involved in goods manufacturing. It includes goods from forestry, agriculture, mining, fisheries and manufacturing etc. The PPI is also an indicator of changes in price of part of growth in the sectors of non-goods producers.
In the context, prices of around 25000 establishments are represented in the PPI. The PPI plays an important role in determining the direction of interest rate as well as extent of change in interest rate required for economic stability. Inflation is directly affected by change in interest rate hence PPI is the very first economic indicator to highlight the effect of any change in monetary policy and its effectiveness.
5. Consumer Confidence Survey
In this economic indicator, few questions are asked from a sample of around 5000 people among which around 3000 to 3500 respond. This survey’s questions include questions pertaining to the feelings as well as thoughts of the business conditions, economic growth, consumer spending, and labor market. It also includes employment and financial expectations for next six months.
Each of the questions in this survey can be responded with three choices i.e. negative, positive and neutral. The Consumer Confidence Survey a key indicator for consumer spending for the consumers regarding their buying practice when they are confident about their employment and financial prospects.
6. Current Employment Statistics
This indicator is based on the survey conducted on 300,000 establishment in around 600 industries. These make up around one third of the employees. These industries include trade in retail sector, construction and manufacturing. This indicator provides information on the number of hours the employees worked and their earnings for the people surveyed throughout the country. The employed people are ones who are ether full time workers, part-time worker, intermittent or temporary workers who got their pay for the duration for which the survey was conducted.
Federal Reserve should include this indicator in the analysis for taking important decisions regarding formulation of various aspect of monetary policy. People on paid vacations and sick leave are also considered in this survey; however, business proprietors, volunteers, unpaid family members and self-employed are not counted as employed people in this economic indicator.
7. Retail Trade Sales and Food Services Sales
The data of retail trade sales and food services sales is acquired through sampling of around 5,000 various food and retail service firms. The data is divided into two major categories in which one includes and the other excludes automobiles sales. These sales are benchmarked while weighing in order to represent retails as well as food services of around three millions retailers and food suppliers throughout the country.
The data acquired in this indicator shows the personal consumption of the consumers in the retail sector while tracking the deceleration or growth in the personal consumption of consumers. This consumption forms around one-third of U.S.’ annual GDP. This data is used by economists and other finance experts to analyze and track trends in the consumer spending while forecasting the magnitude as well as the direction of any future consumer spending.
The high level of volatility forms the basis of separating automobile sector from this data which results in better understanding and representation of consumer spending. Federal Reserve needs to include the data from these indicators in order to effectively formulate a policy that also addresses the consumer spending.
8. Housing Starts (Formally Known as "New Residential Construction")
Variation in mortgage rates highly change the data of housing starts. The mortgage rates are greatly affected by interest rates so the interest rates should be adjusted in the monetary policy while keeping the data of housing starts. This indicator is highly volatile and forms a minute portion i.e. around 5% of GDP, it gives strong signals about the strength of the economy of the country. The long term financial trends can be seen by the experts of the field through analyzing data of housing starts.
9. Manufacturing and Trade Inventories and Sales
The data regarding this economic indicator forms the basis of the information regarding the business sales and inventories state. The rates of inventories represent the highlights regarding contraction or growth in the economy of the country. Federal Reserve needs to include the information of this indicator in formulation of monetary policy in order to ensure that the business sales and inventories are positively affected by it. Any growth in business inventories would simply mean that the businesses are running at slower pace than before. The inventories are reduced when the businesses cut their production to such a level that balances the inventory level.
10. S&P 500 Stock Index (the S&P 500)
The S&P 500 index is the indicator for top 500 stock on the basis of the market size, industrial group and the liquidity of the company. These companies are regularly replaced with new ones in order to make the data more effective. Federal Reserve may consider the data from this economic indicator while formulating monetary policy in order to safeguard the interest of the stock market.

Monetary policies the Federal Reserve might use to influence the money supply

The Federal Reserve uses the following ways to affect money supply: -
1. Open Market Operation: The Federal Reserve can invariably affect money supply through selling or buying securities of U.S. government by using the open market operations. While the Federal Reserve purchases any government’s financial security from public, it is done through utilizing the money that is not present within the system. Therefore, the bank’s reserves would increase hence raising the money supply.
2. The Required-Reserve Ratio: The Federal Reserve can affect money supply through changing this ratio. The ratio specifies an amount that banks must have to hold as a reserves on all the deposits as well as limits any amount that a bank may lend at a particular time. In case if the Federal Reserve increases reserve ratio, deposit as well as money multiplier would be smaller, thus further placing limit on the amount at which bank may enlarge money supply.
3. Discount Rate: Bank borrow money whenever needed. When a bank borrows from the Federal Reserve, it pays interest rate that is called Discount rate. Whenever this discount rate gets raised, all the banks would face a less level of incentive for their borrowing therefore it lowers the overall supply of money in the system of the economy. The time at which an economy is going through the inflationary gap, the Federal Reserve would have to adopt a contractionary type of monetary policy in order to decrease money supply in market through selling the financial securities, raising reserve rate, as well as increasing discount rate. When economy of the country is in the recessionary gap, then the Federal Reserve would adopt an expansionary type of monetary policy in order to increase the money supply within the market through buying the financial securities, while lowering reserve rate, as well as decreasing discount rate.

Using monetary policy in comparison to fiscal policy

Monetary Policy
Monetary policy is a financial tool used by central banks to either increase the economic growth rate or decrease it based on the inflation and various other economic issues. The main idea behind monetary policy is that lowering interest rate encourages people and business to borrow more money and save less of it which also raises demand of everything resulting in raising prices that is known as inflation. On the other hand any decreases in the interest rate reflects more benefits to people and businesses to save money more in banks and lend as less money as they can. The result of such a situation is that people would tend to buy less and save more resulting lowering of demand of goods hence reducing inflation in the economy.

Fiscal Policy

Fiscal policy related tools are in larger number than monetary policy and are of great interest to the politicians as well as economists. The primary targets of fiscal policy include level as well as composition of spending. Change in tax policy is one of the major tool in the fiscal policy formulation. The government may increase spending by consumers for particular goods through decreasing taxes and providing other forms of subsidies. On the other hand, the government may adversely affect or reduce spending by consumers for particular goods like cigarettes etc. to address health issues through putting more taxes on such products. Government may borrow or lend money at higher or lower rates than the prescribed interest rates in order to execute one of these plans.

Effect of the Federal Reserve’s action on the aggregate demand / supply

The Federal Reserve can invariably affect money supply through selling or buying securities of U.S. government by using the open market operations. The Federal Reserve can directly affect money supply through changing required reserve ratio. The time at which an economy is going through the inflationary gap, the Federal Reserve would have to adopt a contractionary type of monetary policy in order to decrease money supply in market through selling the financial securities, raising reserve rate, as well as increasing discount rate and vice versa.

Summary

The federal interest rate is controlled considerably by the Federal Reserve. This control is exercised through influencing the supply and demand of balances at reserve banks level. Any changes in monetary policy result in varying the exchange value of USD in comparison to other currencies. Federal Reserve should analyze few major economic factors to stabilize the economy. The Federal Reserve uses the several ways to affect money supply. Monetary policy is a financial tool used by central banks to either increase the economic growth rate or decrease it based on the inflation and various other economic issues. Fiscal policy related tools are in larger number than monetary policy and are of great interest to the politicians as well as economists.

References

Brezina, C. (2011). Understanding the Gross Domestic Product and the Gross National Product. New York City: The Rosen Publishing Group.
Frumkin, N. (2004). Tracking America's Economy. New York: M.E. Sharpe.
Rabin, J. (2001). Handbook of Monetary Policy. Boca Raton: CRC Press.