Role and effectiveness of the Federal Reserve in stabilizing the economy
The Federal Reserve uses the monetary policy to stabilize the economy. The fiscal policy relies on the Congress, and follows a legislative process (Congressional Research Service, 2014). An expansionary monetary policy involves an action whose aim is to increase money supply, and availability of credit.
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On the other hand, the Federal Reserve can carry out procedures that reduce the amount of money in circulation, and availability of credit. An expansionary fiscal policy refers to using a budget deficit to increase government expenditure (Congressional Research Service, 2014).
The Federal Reserve has a regulatory role to play in the financial markets. It ensures that financial institutions’ operations are within the limits set in the law. The Federal Reserve oversees that financial institutions do not engage in actions that may cause the entire economy to be at risk (Congressional Research Service, 2014).
The interest rates between 2001 and 2003 have been blamed for causing the ‘housing bubble’. Critics claim the interest was lowered for too long, creating unnecessary liquidity. The Federal fund rate was at 1% in mid-2003 (Congressional Research Service, 2014). The low interest rate was able to pull out the economy out of the 2001-recession.
The effectiveness of the extensive open market operations by the Federal Reserve has been criticized for failing to increase aggregate demand. Paying institutions a discount for holding reserves has been criticized for encouraging financial institutions to hold cash, and to avoid risky lending.
The Federal Reserve expansionary monetary policy has not created inflationary pressure. Inflation has remained below the targeted 2% annually (Congressional Research Service, 2014). T
he inflation rate was at 1.824 for all urban consumer goods in 2013 (FRED, 2014). The Federal Reserve has been effective in managing inflation. Critics believe the effect of inflation may be felt later considering the extensive purchase of securities by the Federal Reserve (Congressional Research Service, 2014).
The measures taken by the Federal Reserve are considered less effective because of the amount of finance that the Federal Reserve has used to stabilize the economy. Congressional Research Service (2014) discusses that the Federal Reserve liabilities increased from less than $1 trillion to about $4 trillion as a result of engaging in open market operations between 2008 and 2013.
The stimulus packages have failed to give the expected level of aggregate demand. It has caused the Federal Reserve to use several programs to purchase securities.
The zero lower bound interest also appears to have entered a liquidity trap. However, the Federal Reserve has been effective in stabilizing the financial markets, and creating a real GDP growth. In 2013, the unemployment rate decreased by 6.6% (FRED, 2014). The real GDP went up by 3.2% in 2013 (FRED, 2014).
Economic indicators to analyze
The Federal Reserve can monitor the real GDP growth to find out if the monetary policies they are implementing are effective. Growth in the real GDP is an indication of effectiveness. The Federal Reserve can also examine the changes in the consumer price index (CPI). The CPI shows the level in which prices have changed from the base year. The difference between two consecutive years shows the inflation rate in that single year.
The Federal Reserve can use the consumption level to predict aggregate demand. The Fed uses aggregate demand to determine whether to lower the Federal fund rate. It uses the inflation rate to raise the Federal fund rate. The unemployment rate is also an indicator that has been used to advocate for economic stimulus packages.
The Federal Reserve has been given a mandate by the Congress to manage inflation, and make the economy to operate towards full employment. The first indicator that the Federal Reserve evaluates frequently is the interest rate. Congressional Research Service (2014) explains that the Fed meets once every six weeks to determine the correct level of the Federal funds rate.
The Federal funds rate has a direct impact on the market interest rates. The market interest rates affect the level of consumption. Consumption affects investment, and the level of unemployment.
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Congressional Research Service (2014) discusses that “interest-sensitive spending includes purchase of physical assets by firms, purchase of durables by households, and investment in real estate” (p. 6). High aggregate demand, coming from increased consumption, reduces unemployment. High aggregate demand also increases real GDP through increased investment.
The exchange rate is another indicator monitored by the Federal Reserve. The exchange rate is important because it affects the level of export and imports (balance of payments). The level of unemployment is likely to increase when exports reduce, and imports increase. The Federal Reserve has a mandate to lower the unemployment rate.
The Federal Reserve maintains stability in the foreign exchange rate. The swap lines were used by the Federal Reserve to provide investors with foreign currency, especially the Euro, after 2008 (Congressional Research Service, 2014). In the swap lines, financial institutions would receive Euros in the U.S., which they would use as reserves.
They could give credit to those who need foreign currency (Congressional Research Service, 2014). It is one of the methods used by the Fed to maintain a favorable exchange rate.
The Federal Reserve once chose to lower interest rates over the increase in exchange rates in response to the dollar depreciating widely against the yen. In 1995, the dollar had depreciated deeply against the yen, and the U.S. economy had also slowed down.
Carbaugh (2010) discusses that a restrictive monetary policy would have been the correct procedure to make the dollar appreciate in the 1995-case. The Federal Reserve lowered interest rates, which increased local consumption instead of increasing interest, which would have made the dollar to appreciate.
Monetary policies that the Fed may apply
The Federal Reserve has three options that it can use to influence the money supply. The most commonly used method is the open market operation. It involves purchasing Treasury bills from the financial market when it wants to increase money supply. It sells Treasury bills when it wants to reduce money supply.
Sometimes, Treasury bills are used to raise funds for an expansionary fiscal policy. The Federal Reserve has used the open market operation several times since 2008 to stabilize the economy. It has been used on a large scale basis. It has been used for different kinds of securities such that it has been recognized as the unconventional means (Congressional Research Service, 2014).
The Federal Reserve announced to purchase $300 billion worth of Treasury bills on March, 2009, as an open market operation (Congressional Research Service, 2014). The program was completed in March, 2010. It also purchased $175 billion of Agency debt, and $1.25 trillion worth of Agency mortgage-backed securities (Congressional Research Service, 2014).
The purchase of securities by the Federal Reserve results in an increase in liquidity in the economy. Increased liquidity is supposed to increase aggregate demand in the economy, which operates far from full employment. It creates inflationary pressures when most resources in an economy are fully utilized. The U.S. economy still operates far from full employment.
However, the impact of the open market operations has not been effective as expected. The Federal Reserve has reacted in the same manner, by purchasing more and more securities including unconventional ones. In 2010, it purchased $600 billion worth of Treasury bills.
On September 13, 2012, the Federal Reserve announced the purchase of government-sponsored enterprise (GSE) securities at a rate of $40 billion a month (Congressional Research Service, 2014). The impact is that there is increasing liquidity, but unemployment remains high. The Federal Reserve uses open market operation to control interest rates as well.
The Federal Reserve may use the proportion of reserves that financial institutions are supposed to hold to control the availability of credit. Congressional Research Service (2014) recognizes that the option is rarely used. Bank reserves proportions were last reviewed in 1998. Banks’ ability to offer credit is reduced when the Federal Reserve requires them to keep large proportions of deposits as reserves.
The percentage of reserves that banks are required to hold relies on the size of the commercial bank. It ranges from 0% to 10% (Congressional Research Service, 2014). In 2008, the Federal Reserve was paying a discount to financial institutions that maintained the required reserve, and any excess of the reserves. Banks could earn an interest by holding money in their reserves.
The third option that the Federal Reserve may use is to lend financial institutions cash on a temporary basis. It allows the institutions to issue more credit than their initial reserves. The Federal Reserve uses the Federal funds rate, which affects the level of interest for long-term debt. The Federal funds rate has been set between 0% and 0.25% since the financial crisis occurred in 2008 (Congressional Research Service, 2014).
The interest rates have reached a level known as the “zero lower bound” (Congressional Research Service, 2014). It shows that they have a level in which they cannot be lowered any further. The zero lower bound has limited Federal Reserve options to increase consumptions. It has made the Federal Reserve to resolve into purchasing the conventional Treasury bills, and unconventional securities to increase liquidity.
Monetary policy in comparison to fiscal policy
Strengths of monetary policy
Federal policy provides the opportunity to make instant changes to economic tools that give the desired level of economic activity (Congressional Research Service, 2014). For example, the Federal fund rate can be changed in a single day.
The open market operation can also be conducted by the Treasury when it needs it. On the other hand, fiscal policy involves the national budget. The national budget must be approved by Congress, which may take longer. In most cases, it occurs once in a year.
Monetary policy stimulates activities in many sectors. Actions to reduce or increase interest rates affect many industries. Fiscal policy may target specific sectors when others are isolated.
Monetary policy can be conducted for expansion or reduction of money supply. An expansionary monetary policy can be counterbalanced by a restrictive monetary policy. Mostly, the fiscal policy is implemented for expansion of government spending. Increase in taxes or reduction of deficit usually appears unfavorable to most governments (Congressional Research Service, 2014).
The use of the monetary policy today does not limit its use in the future. On the other hand, the use of an expansionary fiscal policy in the future is limited by the amount of debt the government holds (Congressional Research Service, 2014). High levels of debt increase cost of servicing debt because investors will require higher interest rates. In some cases, the Treasury bill may fail to raise the required amount.
Weaknesses of monetary policy
The monetary policy may reach its limit when the Federal fund rate reaches the zero lower bound rates (Congressional Research Service, 2014). It may require the Federal Reserve to use unconventional means, such as purchasing securities that are not Treasury bills. On the other hand, the fiscal policy is constrained by the national budget.
Very low interest rates are likely to enter the state of a liquidity trap as it can be seen in the U.S. economy. Liquidity trap occurs when aggregate demand becomes insensitive to the low interest rates (Congressional Research Service, 2014).
An expansionary monetary policy when an economy approaches full employment creates an inflationary pressure. It has also been argued that in the long run, an expansionary monetary policy will eventually lead to inflation (Congressional Research Service, 2014).
Inflation occurs after the stream of inducement adjusts to increased demand by producers. On the other hand, an expansionary fiscal policy increases debt, and future national income (Congressional Research Service, 2014).
Aggregate demand-supply model (AD-AS Model)
The AD curve represents an “aggregate of goods and services that will be consumed in the economy at a certain price” (Layton, Robinson & Tucker, 201, p. 350). The total consumption equals the real GDP. The AS curve represents “all goods and services produced in the economy which are also equal to the real GDP” (Layton, Robinson & Tucker, 2011, p. 350).
When the Federal Reserve purchases securities, it increases the nominal GDP. Aggregate demand increases because people have more purchasing power when prices are constant. Producers respond by increasing their level of production when the economy is not operating at full employment.
It results in more demand for factors of production. Wages and raw materials prices may rise, which may result in cost-push inflation. An aggregate demand that has been caused by an expansionary monetary policy may cause inflation in the long run (Congressional Research Service, 2014).
An expansionary fiscal policy that is financed by a budget deficit causes interest rates to increase. Interest rates increase when the government finances its budget by raising capital in the financial markets rather than increasing taxes. An increase in interest rates causes foreign capital to flow into the country (Carbaugh, 2010). The dollar appreciates.
Congressional Research Service (2014) explains that the inflow of foreign capital can only be settled through an adjustment that leads to an increase in imports. An increase in imports reduces aggregate demand for domestic products. Domestic production reduces which causes reduction in aggregate supply. Reduction in aggregate supply reduces real GDP.
The expansionary monetary policies used by the Federal Reserve have been less effective than expected. It has been forced to purchase securities from the financial markets several times without reducing unemployment to the required levels. In 2013, the unemployment level reduced, which is a good report for the Federal Reserve.
Inflation has remained below the targeted 2% level set by the Federal Reserve, which is an indication of good results. However, the impact of an expansionary monetary policy on inflation may be realized in the long run.
Carbaugh, R. (2010). International Economics (13th ed.). Mason, OH: Cengage Learning.
Congressional Research Service. (2014). Monetary policy and the Federal Reserve: Current policy and conditions. Retrieved from https://fas.org/sgp/crs/misc/RL30354.pdf
FRED. (2014). Federal Reserve Bank of St. Louis. Retrieved from https://fred.stlouisfed.org/
Layton, A., Robinson, T., & Tucker, I. (2011). Economics for today (4th ed.). South Melbourne, Australia: Cengage Learning.