The Role of Federal Reserve in the Economic Crisis in 2007 Essay

Introduction

Federal Reserve, also known as the Central Bank of America is one of the most powerful and influential economic institutions. Having been created almost a hundred years ago by the Congress, the Federal Reserve has played a major role especially during major economic crises like the World Depression of early 30s and the economic crisis of 2007.

A part from its role in combating these crises, the Federal Reserve has constitutional powers, which allow it to be relevant to the Congress with the latter taking an oversight role. During the execution of its monetary powers, the Federal Reserve is guided by several aspects of its structure, which promote efficacy in service delivery to the people of America and in handling economic matters. This essay discusses the monetary policy as spelled out in the Federal Reserve Act and how it relates to the U.S economy today.

Federal Reserve

Unlike other financial institutions in the country, the Federal Reserve serves as the Central Bank and therefore has a wide range of special privileges that are important in its functioning. As such, it assumes the functions and attributes of such a bank in the American Financial sector (Saxton 2). As a lender of the last resort, the Federal Reserve is mandated to issue paper money to banks and is recognized as the banker for all government and commercial banks in the country.

While acting as the lender of the last resort, Federal Reserve operates as a bank regulator in order to streamline banking sector within its constitutional responsibilities. Additionally, the operations of the Federal Reserve aim at centralizing reserves in the country; they encompass reserve management responsibilities and the monetary policy. In general, the Federal Reserve maintains the stability of the financial system and oversees the achievement of price within the financial sector (Saxton 2).

Moreover, the significance of the oversight of the Congress in the functioning of the Federal Reserve is imperative. These functions are extremely important in determining the impact of the Federal Reserve in its management of expenditure and inflation-related issues (Saxton 3).

In its implementation of the monetary policy, the Federal Reserve plays a major role in determining short-term interest rates, foreign exchange rates and varied prices within the market. In times of major financial crises like the ones experienced in 2007 and 2008, the bank plays a crucial role in inducing financial stability into the system while acting as the lender of the last resort.

Monetary Policy

As defined in the American constitution, the monetary policy is plays a core role in shaping and stabilizing the economy of the United States. Under the Federal Reserve Act, the Federal Open Market Committee and the Board of Governors are mandated to promote maximum employment for citizens, ensure stable prices and regulate long-term interest rates within the financial sector (Saxton 3).

These three factors are highly interlocked and key determinants in understanding economic trends and implications. For instance, long-term stable prices guarantee sustainable economic growth and overall employment together with average long-term rates, which are charged as interest by financial institutions.

It is also believed that long-term stable prices ensure that the prices of goods and services remain unaltered as a result of inflation and serves as an indicator of proper resource allocation and promotes high living standards. Besides this assurance, stable prices enhance capital formation and saving. This is because when the risk of making losses emanating from inflation is minimized, people are encouraged to increase their saving capacity with more businesses being motivated to invest heavily (Saxton 3).

In understanding the impact of stable prices, it is fundamentally important to note that stability can either be long-term or short-term. Unlike long-term stability which allows sustainable growth and employment in the country, short-term stability of prices may breed a scenario that raises tension between the two major roles of stabilizing prices (Saxton 4). In most cases, low employment rate is accompanied with weak pressures on existing market prices and easing of the policy does not lead to inflationary results.

It is also possible to have a case where higher price pressures are developing with employment going down. This is common during a major supply shock like rising fuel prices in the world. The economic implication of such a case is that the weaknesses within the economy would be compounded by efforts to avert inflation impact. Similarly, efforts adopted to deal with unemployment would worsen inflation in the country.

When such moments arise in financial crises, monetary policy custodians are usually left in a dilemma that presents a case of either neutralizing pressures on price or reducing unemployment and output. Additionally, expected inflation can be detrimental on price stability especially when it gets adopted by price and wage controllers (Saxton 4).

Importantly, the Federal Reserve has a role in promoting financial stability and good economic performance by taking actions that are aimed at mitigating financial disruptions and ensuring that the impact of such disruptions does not spread outside the financial sector (Saxton 4). This is important based on the fact that current financial systems exhibit high level of interconnection and are extremely vulnerable to huge disruptions like the one that may occur as a result of a fall in stock prices.

As such, the Federal Reserve promotes resistance of financial systems towards such shocks by implementing regulatory policies in relation with payment systems and banking institutions. Additionally, it is allowed to reduce how financial markets are affected by giving liquidity through the adoption of open market operations. Similarly, these results can be achieved via discount window lending (Saxton 4).

In its application, the monetary policy plays a significant role in the American economy. This is principally held by markets for balance, which is normally executed at the Federal Reserve Banks.

In general, depository institutions own accounts at their Federal Reserves, allowing them to trade balances maintained in these accounts at a certain interest rate referred to as the federal funds rate (Saxton 5). This funds rate is considerably controlled by the Federal Reserve through its operational impact over the demand for and supply of balances in the Reserve Banks.

Notably, the FOMC usually positions the federal funds rate at an allowed level that would promote financial and monetary conditions to be in line with the realization of set policy goals and objectives (Saxton 6). It however adjusts the target depending on current and evolving economic advancements. Importantly, fluctuations of the federal funds are vital in determining future trends and expectations.

A change in this rate or a deviation towards future expectations can generate a series of events that would affect among others, dollar exchange value, short-term interest rates, stock prices and long-term interest rates (Saxton 6). Consequently, these changes in the above mentioned variables are likely to affect spending decisions among business owners and households, thus affecting growth in demand and the overall economy.

Nevertheless, short-term interest rates are influenced by both the current status of the federal funds rate and future expectations the lie within a short-term financial contract. The implication of this school of thought is that short-term interest rates are likely to drop if a reduction in the federal funds rate is implemented by the Federal Reserve in the form a surprise to all market participants (Saxton 6).

In the same manner, an announcement by the Federal Reserve to increase federal funds rate would lead to an increase in short-term rates. Better still, these results would be experienced if key market participants believed that the federal funds rates were to be held at a higher level by the Federal Reserve than the expected one.

For these reasons, market participants are always concerned with data and statements released by the Federal Reserve official (Saxton 7). They do this by analyzing clues about the economy and prices being on unique paths than expected and this could ultimately impact on the position of the monetary policy.

Furthermore, changes which occur in short-term interest rates impact long-term interest rates like those on corporate bond, treasury notes, consumer loans and fixed rate mortgages. On the other hand, deviations in long-term interest rates may affect stock prices on the market, which may have devastating impact on household wealth (Saxton 7). Additionally, reduced interest rates may have a convincing influence on investors about future strength of the economy and expected higher profits. This may call for the lifting of equity prices.

Conclusion

From this analysis, it is clear that the monetary policy found under the Federal Reserve Act plays a major role in stabilizing the economy and deciding future trends and possible decisions. As key player in the U.S economy, the Federal Reserve has to maintain financial sobriety to give direction during crucial moments like economic crises.

Works Cited

Saxton, Jim. “The importance of the Federal Reserve; A joint economic committee report.” United States Congress, 1997. Web. <https://www.jec.senate.gov/reports/>.

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