Feral Reserve System

ECO499

Money and Banking

23/07/2010

The Feral reserve system faces many challenges in order to provide a healthy economic structure. One of those challenges is for example determining the best solution to solve a crisis that could have different degrees of seriousness. In other words, the FED struggles on how to set the targets that would best affect positively on policy goals. To illustrate this point, we can address the following issue: inflation. As inflation rises, every dollar will buy a smaller percentage of a good. For example, if the inflation rate is 2%, then a $1 pack of gum will cost $1.02 in a year. I was taught in my previous finance class that most countries' central banks would try to sustain an inflation rate of 2-3%.
However if the inflation rate is greater, the FED should intervene in order to stabilize it as targeted. The problem now is how to deal with this situation since there are many way out to solve it. For example, the government can impose restrictions in the transfer of foreign currency reserves outside of the country. Another alternative, the government can do to solve the problem of inflation is to lift certain import controls. These two solutions will lead to reduce the inflation but picking the right one, does not come from an instinct, but from the decision makers. Therefore, a perfect expertise is needed to first study the market at the given time and determine what caused the rise in inflation, then decide what would be the most appropriate conclusion.
According to Eduardo Smith an economist who was a consultant in the FED (Smith, 2001), in the early 1930s were a time of serious deflation and federal price supports were put into place to attempt to stop the downward spiral.
The plan was to use "codes of fair competition" to steady prices for products made by different companies in similar industries. The codes didn't work well for many reasons. Organizing product lines was difficult, the disparate cost structures of the big firms compared to small firms, and the difficulty of setting prices that everyone would consider to be fair were all problems faced. Even when agreements were made, opportunities for evading the codes were
present.
Another new way to get out of a deflationary economic issue is the Quantitative Easing. This involves increasing the money supply by printing more money. It often involves buying government bonds to reduce long-term interest rates and encourage private banks to lend more.
Quantitative easing was introduced in Japan in 2001 to try and overcome their deflationary recession.
Quantitative easing is often suggested as a solution to a liquidity trap, in other words a liquidity trap is a situation in which prevailing interest rates are low and savings rates are high, making monetary policy ineffective. In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings because of the prevailing belief that interest rates will soon raise. Because bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline. . If short-term rates have been cut to 0%, then short-term rates cannot fall any more. Therefore, if deflation is still a problem, one solution is to try and increase the money supply and get out of the deflationary cycle. Some economists argue that quantitative easing can work in cases of deflationary trap. In particular, it is important to change inflationary expectations from deflation to positive
inflation.
According to an article I read on the newspaper, The Fed now expects inflation of 1% or less this year and next, not including food and energy prices. While spending less on purchases may sound appealing to consumers, falling prices and wages can cause much more economic pain than rising prices. (Isidore, 2010).
This is a response from the central bank deal with the crisis when mass printing of money is not enough. The quantitative easing would be an effective method to get out of a deflation so it makes credit terms more attractive by means other than rate cuts. The central banks then begin to buy risky assets, illiquid with mass printed money for the occasion. So banks need to lend heavily again with this money. Thus the revival of the economy is produced by the credit because of the crisis. The risk to boost consumption by cheap credit is going to obviously inflation or even a hyperinflation at the sight of the money printed. The second risk is to have a loss of investor confidence in the dollar, a loss of confidence in the ability of the U.S. state to repay its debts. Hence the scheme precisely creates hyperinflation to decrease the value of that debt.

references

Isidore, C. (2010). The Fed's toughest foe: deflation. CNN Money, Retrieved from http://money.cnn.com/2010/07/20/news/economy/fed_deflation/index.html
Smith, E. (2001). The Code of Fair Competition. Encyclopedia. Retrieved (2010, July 23) from http://encyclopedia.jrank.org/articles/pages/2874/The-Code-of-Fair-Competition.html