Economics

You are to read the following and write a 3-4 page report that answers the questions at the end:

Monetary Policy in the United States

Monetary policy consists of regulation and control over the growth of money and credit in an attempt to pursue broad economic goals such as full employment, avoidance of inflation, and sustainable economic growth. Its principal tools are open market operations, changes in the discount (lending) rate, and changes in reserve requirements behind deposits.

The structure of the Federal Reserve System (commonly known as the FED), is complex, but
some understanding of it is necessary as background to the study of monetary policy in the
United States. The complexity of the FED, which is responsible for the conduct of monetary
policy, stems from the difference between the high degrees of decentralization of that exists on
paper and the high degree of centralization that exists in reality. In addition, there are also
divergent views as to the purpose of the FED. As for example, there is the public interest view
of FED motivation—which holds that the Fed acts in the interests of the general public—and the
principal-agent view—which holds that the FED acts to increase its power, influence, and
prestige as an organization, subject to constraints placed on it by the President and Congress.
One implication of the principal-agent view is that the FED might act to create a political
business cycle: lowering interest rates in order to stimulate economic activity prior to elections.
The evidence in favor of the existence of a political business cycle is, at best, mixed. Arguments
could be made for and against the FED’s independence from the Congress and the President. An
independent FED is said to be able to avoid the myopic tendency of elected officials to be
concerned more with the short-term benefits of a simulative policy than with its long-term costs.

• The argument against an independent FED raises the point that in a democracy a matter as important as monetary policy should be directly in the hands of elected officials. Based on observations in other countries (although the results vary) independent Central Banks (the equivalent of the FED in the United States), appear to improve an economy’s performance by maintaining a lower rate of inflation without adversely affecting output or employment.

Goals of Monetary Policy

The FED has set six monetary policy goals that are intended to promote a well-functioning economy: price stability, high employment, economic growth, financial market and institution stability, interest rate stability, and foreign-exchange market stability.

Inflation rose dramatically and unexpectedly during the 1970s, and policymakers have set price stability as one of policy goals. High employment, or a low rate of unemployment, is another monetary policy goal. Policymakers also seek steady economic growth, increases in the economy’s output of goods and services over time. Financial markets and institutions stability— maintaining the viability of financial markets and institutions to channel funds from savers to borrowers—makes possible the efficient matching of savers and borrowers, and is also considered to be an important goal. The FED goal of interest rate stability, or limited fluctuations in interest rates on bonds, is motivated by political pressure as well as by a desire for a stable saving and investment environment. Last, but not least, foreign-exchange market stability, or limited fluctuations in the foreign-exchange value of the dollar is an important monetary policy goal of the FED.

The Policy Tools of the FED to achieve its goals: Open Market Operations, Changes in the Reserve Requirements, Changes in the Discount Rate

Open market operations consist of the buying and selling securities by the central bank in an effort to influence and shape the course of interest rates and the growth of money and credit. Open-market operations (or OMO), therefore, affect bank deposits ~ their volume and growth — as well as the volume of lending and the interest rates attached to bank borrowings and loans, in addition to the value of bank stock. OMO is the preferred tool, because it is also the FED’s most flexible tool. It can be used every day and any mistakes can be quickly reversed.

Reserve requirements are the amount of vault cash and deposits at the Federal Reserve banks that depository institutions raising funds from sources of reservable liabilities (such as checking accounts, business CDs, and borrowings of Eurodollars from abroad) must hold. If the FED loans $200 million in reserves from the discount window, total reserves will rise by the amount of the discount window loan, but then will fall when the loan is repaid.

The Discount Window is the department in each Federal Reserve Bank that receives requests to borrow reserves from banks and other depository institutions which are eligible to obtain credit from the Fed for short periods of time. The rate charged on such loans is called the discount rate.

To encourage greater use of the discount window and to bring greater stability to the federal funds rate and the money market as a whole, The FED created two new loan types – primary and secondary credit; these replaced the existing adjustment and extended credit. Primary credit is extended to sound borrowing institutions at a rate slightly higher than the federal funds rate. Secondary credit is extended to institutions that do not qualify for primary credit for temporary funding needs at a rate slightly above the prime rate.

 

Challenges in Achieving Monetary Policy Goals

A policy that is intended to achieve one monetary policy goal may have an adverse effect on another policy goal.

The FED’s tools don’t always allow it to achieve its monetary policy goals directly. The FED also faces timing difficulties in using its monetary policy tools and attempts to solve its problems in achieving monetary policy goals by using targets. These are variables that the FED can influence directly and are aimed at achieving monetary policy goals. Targets that the FED employs are either intermediate or operating. Intermediate targets are financial variables that the FED believes will directly help it to achieve its goals while operating targets are variables that the FED controls directly with monetary policy tools and are closely related to intermediate targets.

It should be noted that the FED uses similar criteria in selecting its operating targets as it uses in selecting its intermediate targets. In addition, the operating target must be consistent with the intermediate target:

1. the first criterion for a good target variable is that it must be measurable in a short time frame
   to overcome information lags;
2. an effective intermediate target must be controllable, or responsive to the FED’s attempts to
   shift course
3. the FED needs targets that have a predictable impact on policy goals;
   1. two problems with interest rates as intermediate targets are that the FED’s influence over real
      interest rates is weaker than its influence over nominal interest rates and a FED policy to
      stabilize interest rates may be inconsistent with the FED’s goal of maintaining steady
      economic growth;
   2. if shifts in the money demand relationship occur frequently, money supply targets will likely
      produce interest rate fluctuations that destabilize the economy;
   3. the FED chooses between money supply targets and interest rate targets on the basis of
      whether it thinks the sources of fluctuations in economic conditions arise more from the real
      or the financial sides of the economy.

The “Other” Responsibilities of the FED

Many services needed by banks are provided by the Federal Reserve Banks. Among the most important services provided by the FED are checking clearing, wiring of funds, shipments of currency and coin, loans from the Reserve banks to qualified depository institutions, and supplying information concerning economic and financial trends and issues. The FED began charging for its services in order to help recover the added costs of deregulation that made more institutions eligible for Federal Reserve services and also to encourage the private marketplace to develop and offer similar services (such as check clearing and wire transfers).

You are to write a 3-4 page report that answers the following questions: Questions:

1. Identify at least three problems facing the FED in achieving its goals of monetary policy and
give your recommendations on how to deal with each of the problems you list.

2.  Identify and explain at least three ways that the Federal Reserve affects the banking system through open market operations (OMO).

1. Explain how changes in reserve requirements and the discount rate affect the operations of
   banks and other depository institutions.
2. Explain why the FED cannot set intermediate targets in terms of both monetary
   aggregates and interest rates.
3. Update the case information by using at least two (2) data sources in addition to the text.

The format of the report is to be as follows:

• Typed, double spaced, Times New Roman font (size 12), one inch margins on allsides, APA format.

 

• Type the question followed by your answer to the question,
• Include a title page and a reference page.