Federal Reserve System: The Multiplier Effect Essay

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The Federal Reserve use open market operations to control short-term interest rates, which is the principal tool of monetary policy. The Federal Open Market Committee on a regular basis announces the federal funds rate targets, and they reflect rates for interbank lending (FOMC, 2009).

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It is responsible for maintaining interest rates at appropriate levels and suitable supply of money to ensure stable economic growth. It was agreed by the Federal Reserve committee, as confirmed on press release dated December 16 2009, to acquire mortgage security worth $1.25 and debt of $175 billion. FOMC through a press statement agreed to steadily reduce Fed security purchasing rate to facilitate smooth changeover. The Fund rate of 0 to ÂĽ % was to be maintained.

The reason for this policy was because the economic recovery was continuing, though at a rate that was insufficient to bring about a significant improvement in the labor market conditions. Household spending increased but remained subdued by escalating unemployment rates, slow growth in earnings, expensive housing, and costly credit.

While spending on business inventory was increasing, fixed asset investment was at minimal rates. Employers were unwilling to increase employees’ salaries. The housing sector was faced by Depression. This proofed that the depression was fading away but its effects would be witnessed for a period of time.

High reserve requirements lead to tight supply of money causing low multiplier effect. On the other hand, lower reserve requirement leads to more money in the economy thus more multiplier effect. To ensure increase of money supply in the economy, FOMC decided minimized purchase of its securities. The lower fund rate would cause a significant decrease in unemployment (or increase in inflation at a mild level), and a higher multiplier effect.

The consequences of this policy are that it would lead to more money supply in the economy which will enable attainment of financial stability and economic growth at the desired level. This is because, the businesses would be a position to lend from banks at a lower rate and invest in fixed investments. This results to more business’ expansion leading to more productivity, increased salaries on employees and more job market.

Consequently, house acquisition and spending by households would increase due to stronger labor market, higher income growth, and higher housing wealth and ease availability of credit. This would ultimately cause higher multiplier effect, business’ growth and hence more revenues to the government. More so, the committee support on mortgage lending would largely improve housing sector, thus advancing the living standards of people.

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Allan, (2009) argued that if the Fed were afraid of inflation, would not increase the monetary base. This would result to turn down in the effective money multiplier. This would consequently lead to a high decline in the money supply. A large deflation would result creating a situation of serious depression. Thus, the decrease in the money multiplier was hence likely to be even higher.

Everyday, the Federal Reserve engages in Open market operations. Its application meant that there would be controlled rate of interest and money in circulation, hence facilitating higher multiplier effect. When they required increasing supply of money, they buy more securities from banks and increased funds rate. When they required reducing the money supply, it sells securities to the banks and increased the fund rate. This ensures inflation rate is controlled at a suitable level for a health economy.

Reference

Allan H. M, (2009). A History of the Federal Reserve.

“Board of the Governors of the Federal Reserve System”, (2009). Press Release—FOMC statement—December 16, 2009..

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IvyPanda. (2019) 'Federal Reserve System: The Multiplier Effect'. 6 May.

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IvyPanda. 2019. "Federal Reserve System: The Multiplier Effect." May 6, 2019. https://ivypanda.com/essays/federal-reserve-system-the-multiplier-effect-essay/.

1. IvyPanda. "Federal Reserve System: The Multiplier Effect." May 6, 2019. https://ivypanda.com/essays/federal-reserve-system-the-multiplier-effect-essay/.


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