Sample Paper on The Role of the Federal Reserve on the Economy

The Role of the Federal Reserve on the Economy


Following a series of financial crises, panic, and banking runs, Congress passed the 1913 Federal Reserve Act which was signed by the then President Woodrow Wilson and created the Federal Reserve System. The Federal Reserve comprises of twelve public-private district Federal Reserve banks. The Federal Reserve is tasked with the management of U.S monetary policy, which regulates bank holding companies and other financial institutions and monitor systematic risks. A board of governors manages the Federal Reserve. The President selects the board members and is subject to approval by the Senate.

Congress has entrusted the Federal Reserve (Fed) with the monetary policy responsibilities though it oversights to make sure Fed adheres to the statutory mandate of maximum employment stabilizing prices and moderation of interest rates. The Fed acts as the Central Bank in the U.S. The Fed’s responsibilities fall into four major divisions. They include monetary policy, providing emergency liquidity by acting as the lender of last resort, supervising financial institutions, and providing payment systems both to the government and to financial institutions. A change to the amount of money and credit in circulation will affect the interest rate and the economy at large. The Fed’s monetary policy role is among the much collective demand management.

Monetary policy refers to the actions that the Fed undertakes in order to manage the amount of money and credit in circulation in the U.S economy to uphold the goals and objectives that it is mandated to carry by the Congress – stable prices and maximum sustainable level of employment. The expectations of both the consumers and businesses have a greater influence on the expenditure trends in the U.S, which are themselves influenced by the measures taken by Fed. Therefore, a broader description of monetary policy would incorporate directives, policies, economic forecasts, and the measures by the Fed. The Federal Open Market Committee (FOMC) assembles occasionally to review the current position of monetary policy.

From the 2007-2008 financial crisis that hit the economy, direct lending become crucial once more both through the discount window and other means that the Fed created. This means injecting funds, credit, and liquidity to depository banks and loans to other institutions that do not belong to the depository banking system. As the situation continues to normalize, the emergency lending has been cut down with an exception of foreign central bank liquidity swaps. Currently, the US economic freedom score stands at 75.5% and is 12th in terms of freest economies according to the 2014 index, and the economic conditions continue to stabilize.

The main role of the Fed is to ensure sufficient availability of money and credit for continued economic growth and development while regulating inflation. To achieve this, Fed uses various tools and means – both traditional and unconventional methods. They include the discount rates, reserve ratio requirements, and open market operations. This paper reviews and discusses the role of the Fed in the national economic goals particularly to unemployment, inflation, and economic growth using various tools and means. It discusses the tools that Fed uses to stimulate the economy both traditional and nontraditional.

How the Fed Utilizes its Mandate to Achieve its Goals through Various Tools

Open Market Operations: This is majorly elastic and it is the primary method used fiscal policy tool by the Fed to control money and credit. It involves the sales and buying of U.S Government Treasury Securities. The FOMC sets the monetary policies, which are implemented by the Federal Reserve of New York. When the committee reaches a consensus to increase the amount of money and credit in circulation, Fed purchases the existing Securities from the open market crediting the accounts of the financial institutions that participated in the transactions. It buys the Securities using newly issued currency. This expands the reserve base of financial institutions and they have more ability to lend on low-interest rates to encourage and attract borrowers. This raises the amount of cash and credit in the flow. On other hand, if the Fed wants to contract or reduce the amount of money in circulation, Fed sells the government securities. This condenses the amount of cash in the flow.

The Reserve Requirements: Fed requires financial institutions to keep a certain percentage of their total deposits and hold it in Reserve Banks irrespective of whether they are associates of the Federal Reserve System. The reserve can be either cash or deposits at the Fed. The Fed has the go-ahead to set the ratio. If the reserve ratio is increased, banks are left with smaller amounts of money and credit to their disposal and to lend. This reduces the amount of money and credit that is circulating. On the other hand, when the Fed lowers the reserve requirements, banks have more money to lend, thus raising the availability of money and credit. Currently, the rate stands in the range of 0% and 10% depending on the size of the financial institution. The Reserve requirement is not used regularly as a monetary policy tool – the rate was updated lastly in 1998.

The Discount Rates: The Fed allows financial organizations to borrow money and credit from it directly on a temporary basis at the discount window. This means that the institutions can discount some of their own assets to the Fed so that it can give them short reserve access. The Fed charges an interest rate (Discount rates) on these advances. Unlike in the open market where the interest rates are determined by the interaction of forces in the financial market, the rates are determined by the directors of the Federal Reserve banks and subject to adoption by the board of governors. Any adjustment in the discount rate hinders or encourages banks to lend and indirectly affects the rate banks pay to their depositors and charges to their borrowers.

Moral Suasion: In this case, the Fed uses persuasion and request depository banks to control money and credit availability. To reduce inflation, Fed persuades depository banks to cease lending for speculative and non-essential reasons. On the other hand, to overcome deflation, the Fed persuades the deposit banks to broaden credit availability for various purposes. In this regard, Fed asks the financial institutions to cooperate with it to attain monetary policy goals and objectives. The Fed has been encouraging depository banks to expand their lending capacity to businesses for sound economic growth and recovery.

Due to the recent economic recession that was experienced in 2007, the Federal Reserve lowered the federal rate to a range of 0% and 0.25%, which is referred to as zero lower bound. The Fed cannot lower the rate beyond this point to stimulate growth. Since then, the rate has not been changed and will continue to be like that until the unemployment rate goes below 7%. Furthermore, the Fed stretched its liquidity services. This was a move directed to ensure that financial institutions had access to funds that they require for their daily operations. Under normal situations, the Federal Reserve provides loans only to depository banks – through discount window lending. However, in 2008, investment banks that included dealers of government securities were faced with the challenge of accessing short-term funding and became vulnerable. To counter this financial shock, the Fed expanded its credit facilities to non-bank institutions and to some of the financial markets, which has seen the economy, improve.

The Fed also innovated and made liquidity available through auctions and standing facilities to overcome businesses’ unwillingness to borrow from the Federal Reserve by fearing that the borrowing could be a plan by market players and portrayed as an indicator of financial fault. In this case, firms have to place their bids on the rate of interest they would wish to pay for the cash they borrow – which is different from the discount window, which publicizes the institution’s need for credit, which may raise solvency fear to some depositors and economic stability at large. As an extra tool to counterbalance sheet concerns, the Fed introduced Securities Lending facilities, which allowed financial institutions to exchange out mortgage-backed collateralized debt obligations (CDOs) with U.S Treasuries.

The Fed has acted to improve the state of two vital markets that fell during the recession – money market mutual funds and short-term lending to businesses. The money mutual funds accumulate credit from investors and avail the funds to short-term undertakings like Treasury bills and availing credit to borrowers on a short-term basis without security, known as commercial paper. At some point, investors started pulling out of the mutual funds due to one of the market players being declared bankruptcy. This caused interest rates to rise affecting the market at large. Fed availed secured loans to the institutions in these markets, a move that ensured adequate funds.

The Federal Reserve’s Set of Unconventional Monetary Policies

Large Scale Asset Purchases (Qualitative Easing –QE)

The fed enacts quantitative easing by producing money and uses the money to purchase bonds, securities, and other assets from depository banks. In this case, depository banks have extra cash available to them for lending. In addition, the Fed’s involvement in buying securities drives up their prices due to the reduced supply. This causes their returns to below, which in turn stimulates the economy by reducing the rate of borrowing.

In 2009, demand for credit from the Federal Reserve started to decrease as the economic state stabilized. At the same time, the federal funds rate was at the zero bound. Fed was faced with responsibility for deciding on whether to give additional monetary stimulus programs through unconventional monetary measures. The first decision was to determine whether to preserve the eminent level of liquidity in the financial system given that the demand was falling. The Fed resolved that the market was still weak and required stimulus. In March 2009, the Fed pronounced a plan to buy $300 billion of Treasury securities, $200 billion of Agency debts though it was revised later to $175 to their availability issues and $1.25 trillion of Agency mortgage-backed securities. The purchase was concluded in 2010.  From that time, direct loaning by Fed has gradually decreased whilst at the same time, the Fed’s worth of both the Treasury and Agency Securities have steadily improved. This move by the Fed was in an effort to maintain the balance sheet stable. On completing the purchases, Fed had to decide on actions to take on maturing assets to stabilize its balance sheet. Fed decided to purchase Treasury Securities to swap the mature securities.

QE2: Fed was not satisfied with the slow economic growth and high level of unemployment and it decided to stimulate the economy by buying an additional $600 billion of Treasury Securities. The buying was done at a pace of $75 billion per month. During this time, Fed announced that it would keep on buying Treasury  Securities and replaying maturing securities with a focus on securities that mature within 2 ½ and 10 years.

QE3: The Maturity Extension Program (as discussed below) ended in 2012, at a point where the Fed announced that it would continue to buy $45 billion of the government-sponsored enterprise (GSE) mortgage-backed security (MBS) every month. The contrast to the earlier two large-scale buys, Fed did not specify the termination date of purchasing but instead pledged to go on buying until the labor market stabilizes. In late 2013, the Fed started lessening asset purchasing steadily and from early 2014, Fed would only buy $35 billion MBS and $40 billion Treasury securities per month. In case the economy continues to recover, it is anticipated that the net asset buying will be minimized to zero. Smaller asset-buying can still be said to be an expansive monetary policy though it stimulates the economy lesser compared to previous plans.

Maturity Extension Program

In 2011, the Fed announced the Maturity Extension Program commonly known as Operation Twist. In this case, Fed bought $667 billion in long-term Treasury securities and at the same time sold an equal sum of Treasury securities on short-term.  Unlike QE, this program has no effect on the size of the Fed’s balance sheet, bank reserves, or monetary base and it is inhibited in size by the number of short-term securities that the fed holds. Because of this, the Maturity Extension Program would only have a smaller effect on economic growth, interest rates, and inflation compared to the same amount of Treasury securities under QE.

By reducing the availability of longer-term treasury securities in the market, this move should decrease the longer-term interest rates as well as the rates on financial assets that market players believe to be close substitutes of longer-term Treasury securities. The decreased longer-term interest rate eases the financial market condition that in turn supports the economy to recover.

Forward Commitment/Guidance

For Fed to carry out its mandate effectively, clear communication is crucial especially when the situation of the economy requires extra policies to stimulate it even when the traditional monetary policy tool is already effected to its lowest point – as the case has been in the recent past. Through forward guidance, the Fed gives a hint to the consumers, companies, and financiers on the position of monetary policy that is projected to exist in the future. By giving this information, on how long the Fed anticipates to keep the target for the federal funds rate outstandingly low, the forward guidance information can push downward pressure on longer-term interest rates and in so doing lowering the cost of credit for consumers and firms and stimulating the economy at large.

This is another tool that the Fed has used in the recent past in an effort to accomplish extra monetary stimulus at the zero bound. In this case, the fed has promised to maintain the federal funds rate at the lowest level for an extended time. Fed policymakers have indicated that the rate will be maintained as far as the unemployment rate is above 6.5% and inflation is about 2%. For this reason, Fed assumes that this move will stimulate the economy, as businesses are more likely to acquire long-term investment commitments by the confidence installed to them when rates are guaranteed to be low throughout their borrowing.

What the fed should do to stimulate the economy

The Fed should improve its communication on how it will react once the state of the economy has improved and the unemployment rate falls below 6.5%. The other thing that the fed should do is to cut the rate of interest that it pays to depository banks on their reserves from the current level of 25 basis points. It should even cut the interest that it pays to the excess reserves below the zero mark. This will show its seriousness towards its target for inflation of 2%. The Fed should create a full-allotment lending plan that will enable depository banks to borrow – with high-quality collateral – at a term of up to 2 years and at a fixed rate of 0.025%.

Fed must also decrease the rates on longer-term Treasury securities by aiming the interest rate on four-year Treasury securities and critically buying the securities when their returns exceed the targeted rate. That is, it should reduce it to 75 basis points from the current 1%. by taking this move, will bring down the longer-term returns thereby reducing a wide range of private borrowing rates. At the same time, the move will encourage business investment, support the housing market, and stimulate exports through a weaker dollar.  On the other hand, bringing down returns on shorter-term to medium-term treasury securities is a precise tool and strategy to fight deflation.

The Fed through its chair should advise Congress to enact an Act that will enable it to extend financial assistance to financial institutions that are not in the category of depository banks. This is because the failure of some of these institutions can have a greater negative impact on the economy. Though the Fed extended financial support during the 2007 financial crisis, it is important to have an Act that delegates and governs the process.

A number of economists argue that the US economy is experiencing a “new normal” due to the financial crisis, a point that I much do agree with. This is because the economy is faced with a number of obstacles. The country’s demographic shifts continue with the baby boom age bracket going into retirement and this will gradually continue to decrease labor force participation thus moderating growth. Continuing to decrease the federal expenditure will slow economic growth and cap unrestricted spending on projects that would generate jobs. Furthermore, the impacts of the depression on pot