Economics

Federal Reserve System and its operations

Question One

The Federal Reserve System (FED) is in charge of the management of the monetary policy. FED, through the monetary policy, regulates and controls the increase of money and credit. Through this, FED aims to pursue and implement its economic objectives such as increase in employment, stabilize prices reduction in inflation and ensure sustainable economic growth. It also aims to stabilize the financial markets, foreign exchange markets and institution sin the economy (Mishkin, 2007). However, FED does go through some problems in the attempt to achieve the monetary policy goals.

There are basic problems that limit FED in its operation. For instance, money is kept in various forms such as coins and paper currency, which also come in different denominations. It is hard for FED to decide on which of the forms to target. The quantity of money held in different time’s changes frequently depending on people’s preferences and many other factors. This makes it hard for Fed to implement the monetary policy, as it is hard to locate the option to target. The solution to the problem would be Fed conducting a comprehensive research in order to know how money is held at different times and periods.

Another problem that FED faces in achievement of its goals is that there is conflicting analysis of its objectives and purpose. For instance, there is the principal-agent view and a public interest view. The public interest view promotes the idea that FED should work to promote the interests of the general public. It is therefore part of the government. This makes FED directly accountable to the general public. It makes FED act in ways that will appease the general public. On the other hand, the principal agent view promotes the idea that FED works or should work to enhance its authority, reputation and influence as an organization. This view assumes that FED is a private organization. The solution to this is the provision of clear set of objectives for FED to guide it in its operation.

Another problem is political interference or non-independence from the government resulting. This leads to the issue of FED been influenced by the government in its operation. The political class might use FED for political activities. For instance, the political class may influence FED to reduce interest’s rates in order to encourage economic activity just before an election. FED works to create a political business cycle depending on the limitations placed on it by the president or congress. This limits FED’s ability to achieve its monetary goals. The solution to this problem is that FED should be clearly independent of the government.

 

Question Two

FED maintains control over the banking system by use the open market operations system. FED uses the Open market operations to control the national amount of money in supply and interest rates. It is used to control and effect the supply of reserves in the banking system. FED does this by buying and selling of government securities and financial instruments (Meek, 1973). Examples of Government securities include treasury bonds, notes and treasury bills. FED uses interest rates and exchange rates to as a guide in the control of money supply. To increase the money supply in the banking system, FED purchases securities such as government bonds from the banks. This increases the amount of money that the banks have at their disposal. It increases the amount available to lend. This stimulates the economy and lowers interests’ rates. To reduce the money supply, FED sells securities to the banks. This will increase interest rate and slow down the economy. This is carried through the System Open Market Account (SOMA). The trade of securities through SOMA helps change bank reserve balances. They also change the short-term interests’ rates. The decisions involving activities carried out by SOMA are controlled by the Federal Open Market Committee (FOMC). OMO is FED’s most preferred tool as it flexible and its shortcomings can be easily corrected.

 

Question Three

Reserve requirements and discount rates also have an effect on the performance and operation of banks and other depository organization. Reserve requirement is the bank provision that describes the lowest reserve that a bank or depository organization should hold on customer deposits. The deposits are either stored in the cash vault or in the Federal Reserve Bank. The discount rate on the other hand represents the interest rate or amounts that FED charges to banks for amounts borrowed (Meek, 1973).  They both have major affects on the economy, performance of banks, borrowing trends and interest rates.

A low reserve requirement acts as an expansionary policy. It requires the banks to hold lower deposits therefore increasing the amount of money at the disposal of the banks and depository institutions. It ensures that they have a higher amount of money to lend which stimulates the economy and lowers interest rates. It also increases the banks profits, as they will lend more making more money. A high reserve requirement acts as a contract ional policy. It increases the amount banks must have as deposits which reduces the disposable amount that can be lent out. This slows down the economy, increases interest rates and reduces profits for the banks (Mishkin, 2007). Frequent changes in the reserve requirement are also costly on banks, as they also have to change their policies every time there is a change.

The discount rate also affects the operations of banks. When the Federal Reserve sets a high discount rate, this discourages banks from borrowing from it. This reduces the amount of money available to the banks to lend. This reduces the banks ability to offer loans and acts as a contract ional policy. It results to interest rates rising; spending levels fall and increase in unemployment. When the Federal Reserve lowers the discount rates, banks borrow more form the Federal Reserve Bank. This increases the amount of money available to lend. This increases the revenue of the banks from interests through loans and expands the economy (Mishkin, 2007).

 

Question Four

However, at times FED is unable to set intermediate targets on both the monetary aggregates and interest rates. The reason why it is unable to set intermediate targets is that FED has very weak control and influence over interest rates. Another reason is that a policy to even out interest rate by setting intermediate targets contradicts with its goal of maintaining a stable economic growth. Any changes in the interest rates change the demand for goods and services. These changes result to a variation in the economic condition. The economic change results because changes in the interest rate modify borrowing costs, the availability of bank loans, the foreign exchange rates and the household wealth. All these changes result to frequent changes in the economic conditions. The change in the interest rate causes a change in the level of output and inflation. FED is unable to set the intermediate targets because of its weak control on interest rates. The reserve level or the supply of money in the economy determines interest rates. Therefore, for FED to alter the interest rates, FED has to alter the reserve level. Modifications on the reserve level usually have many effects on the economy. Therefore, in order, to maintain the economic stability, FED may opt not to alter the supply of money in the economy. This limits its ability to set intermediate targets on monetary aggregates and interest rates.

 

References

Meek, P. (1973). Open market operations. New York, NY: Federal Reserve Bank of New York

Meek, P., & Federal Reserve Bank of New York. (1969).Open market operations. New York, NY: Federal Reserve Bank of New York

Mishkin, F.S. (2007). The economics of money, banking, and financial markets. Cambridge: Pearson Education