Free «The Federal Reserve» Essay Paper

Role and Effectiveness of the Federal Reserve in Stabilizing Economy

Federal Reserve System is a central element of the banking industry structure in the United States. Its background has been set in 1913 by the Congress, in order to grant security, stability, and safety of the financial and banking system in the country. As time passed, functions and role of the Federal Reserve System in the U.S. economy have extended.

Currently, the Federal Reserve System role in the economy is attained through its policies and functions in the following four spheres of economy: monetary policy, banking industry, financial system, and provision of financial services to depositary institutions. Firstly, the Federal Reserve is carrying out monetary policy aimed at stabilizing credit and monetary situations, with further causes price stabilization, low unemployment rates, and reasonable interest rates. Secondly, the Federal Reserve is regulating and supervising banking industry in the country, in order to secure its safety and reliability for American consumers. Next, the Federal Reserve is responsible for sustaining stable functioning with minimal risk environment of the financial system and financial markets. Finally, it provides financial services to depositary institutions, including the U.S. foreign official institutions, government to operate a country’s payment system (Fox, Emerson, & Malphrys, 2005).

 

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The Federal Reserve System is comprised of the Federal Open Market Committee, Board of Governors, and Federal Reserve Banks, located in twelve regions of the country. The Board is a central governmental agency that is located in Washington, D.C. It controls and regulates activities of financial institutions, as well as performance of the federal government, in order to provide secure and just environment for consumers of banking industry products.

Federal Open Market Committee is a major component of the Federal Reserve System. It is made of the members of the Board, head of the Federal Reserve Bank in New York, as well as heads of other four Federal Reserve Banks that are elected on the rotating principle. Major function of the Federal Open Market Committee is to forecast open market operations that are primary toll of the Federal Reserve System to sustain favorable monetary and credit conditions (Fox, Emerson, & Malphrys, 2005).

In addition to the open market operations (buying and selling securities in the open market order to regulate the rate of balances of depositary institutions in the Federal Reserve Banks), Federal Reserve Bank conducts its monetary policy with the help of other tools, including regulation of the norm of reserves (condition set by the Federal Reserve that requires depositary institutions to keep a certain amount of their deposits in the form of cash or alternatively in the Federal Reserve Bank account), contractual clearing balances (additional reserved cash or account at the Federal Reserve Bank that depositary institution agrees to save) and discount window lending (special lending programs for According to the report of Federal Reserve to Congress, economic activity in the country has increased mildly in 2011 (Board of Governors of the Federal Reserve System, 2012). This pattern was sustained also in the labor market when unemployment rate has decreased from 9% at the beginning of the year to almost 8% at the beginning of 2012. At the same time, consumer price index has also fallen in the second half of 2011. Considering observed economic conditions, the Federal Open Market Committee have undertaken a number of policies in the second half of the 2011 in order to deliver further monetary policy stability and economic enhancement. In particular, Federal Open Market Committee has modified the forward rate guidance, increased the average maturity rate of the Federal Reserve security holdings, and also shifted the reinvestment of principal payments on agency securities from Treasure securities to agency guaranteed mortgage-backed securities (Board of Governors of the Federal Reserve System, 2012). Therefore, it is clear that Federal Reserve Bank has a crucial impact on the economic development of the country. Its policy and regulations, particularly in 2011, were effective in sustaining economic growth, low inflation, and unemployment rate.

Economic Indicators of the Federal Reserve

In the course of developing and implementing monetary and regulatory policy, Federal Reserve Bank takes into consideration a set of economic indicators in order to exercise its impact on the whole economic development and growth. In particular, it analyzes rate of inflation, employment participation rate, as well as the unemployment rate, real GDP along with reserves rate (Haskell, 2012).

Inflation rate is a consumer price index that reflects percentage change of the general price level in the country. It measures deterioration of the purchasing power parity of consumers when general price level is increasing. At the end of 2011, Federal Reserve Bank has managed to stabilize consumer price index. Latter, it has increased by only 0.2% in the first two months of 2012.

Low unemployment rate is one of the targets of the government and measures share of the labor force that is currently not employed but actively search for employment. Federal Reserve Bank is exercising its policy, to attain low unemployment rate and increase labor force participation. In February 2011, labor force participation has increased by 227, 000 people while the unemployment rate was stabilized at the rate of 8.3% (Haskell, 2012).

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Real GDP is an indicator that is usually used to measure economic growth and development of the country. It measures the market value of all products that were produced on the territory of the country during a year. According to estimates of BEA, real gross domestic product in the United States has increased in the last quarter of 2011 by around 3%.

Rate of reserves is set by the Federal Reserve Bank and measures amount of resources that depositary institutions should keep in cash or at the account in the Federal Reserve Bank. Recently, Federal Reserve Bank has been extensively using this tool to accelerate recovery from the economic and financial crisis. In particular, it has maintained rate of reserves in the range from 0% to 0.25%, ever since the end of 2008 (Haskell, 2012).

The Federal Reserve Bank in the course of implementing its monetary policy primarily is using three tools, including regulation of the reserve requirements, discount rate, and open market operations (Federal Reserve Bank, 1997).

Regulation of the reserve requirements is an important tool in guiding monetary policy, money supply available in the economy, and interest rates offered by depositary institutions. Reserve requirements represent share of financial resources of the depositary institutions that they are obliged to maintain reserved, against particularly specified deposit liabilities. Within certain limits that are specified by the law, the Federal Reserve is regulating rate of required reserves. Depositary institutions, therefore, are required to keep this amount of resources in the form of cash or deposits at the Federal Reserve Banks.

The amount of cash resources that depositary institution is required to sustain is identified by calculating the reserve ratios to an institution's reservable liabilities. Ratios are specified in the Regulation D of the Federal Reserve Board. These reservable liabilities comprise non-personal time deposits, net transaction accounts, and Eurocurrency liabilities. Since December 27, 1990, Eurocurrency liabilities, as well as non-personal time deposits, have had a reserve ratio of zero (Federal Reserve Bank, 1997).

Net transactions accounts’ reserve ratio depends on the amount of net transactions accounts that depositary institution has available. The 1982 Garn-St Germain Act has set the first $2 million of reservable liabilities to be fee reserving. This amount that is exempted from being reserved is reconsidered every year according to a formula, presented in the Act. The 1980 Monetary Control Act has identified amount of the net transaction accounts to be subjected to a reserve requirement ratio of 3% when it reaches the level of $25 million. This threshold is also reconsidered annually. Currently, net transaction accounts that exceed $25 million are reserved at the 10% rate.

In particular, when real interest rate decreases, the cost of borrowings is reduced as its consequence. This situation creates incentives for businesses to increase their investments. Therefore, households receive more opportunities to purchase larger amounts of durable goods, such as cars, houses. Hence, reduction of interest rates is associated with consequential increase in the aggregate demand.

Decreased real interest rates are also associated with increased attractiveness of stocks, as well as other financial instruments and derivatives. Consequently, prices of common stocks increase. Those households that have made investments into stocks and have got them in their financial portfolios experience increase in their overall wealth and available financial resources and, thus, expenditures.

Considering the short run effect of the decreased interest rate, it should be mentioned that it is associated with reduction of the foreign exchange rate that consequently lowers the general price level of the domestically produced goods in the country. Therefore, this brings higher aggregate spending of consumers on goods and services that are produced inside the U.S.

Similarly, increase of the interest rate in the economy leads to the reduction of the aggregate demand in the country, decrease of investments. Hence, monetary policy exercised by the Federal Reserve Bank has a substantial impact on the aggregate demand and supply in the country (Federal Reserve Bank of San Francisco, 2004).

Conclusions

The Federal Reserve Bank of the Unites States is a central element of the banking industry in the country. It is comprised of the Board of Governors, regional Federal Reserve Banks. Additionally, Open Market Committee is another crucial element of the Federal Reserve System in the United States. Altogether, they determine, implement, and control monetary policy, stabilizing financial sector of the economy. Using reserve rate, discount rate, and open market operations as major tools of monetary policy, the Federal Reserve Bank attains stable economic growth, low unemployment rate, and price stability. At the same time, its policy substantially affects real economic sector and makes a considerable impact on the country’s aggregate demand and supply. Increasing the real interest rate, Federal Reserve Bank can achieve substantial impact on the consumers’ expenditures, and get overall increase in the aggregate supply and demand in the economy. At the same time, reduction of the real interest rate is associated with lower investments rates, decreased aggregate supply, and reduced aggregate demand in the country.