Role of the Fed in the Economy

What is the Real Role of the Fed in the Economy?
Monetary Policy Cause and Effect
EC301 Intermediate Macroeconomics
5 May 2013

The current status of the United States economy is a common discussion or topic in today’s media and in many individuals’ households. The state of the economy affects us all in nearly every aspect of our lives. Whether you’re grocery shopping, buying gas, registering your children for school, or exploring insurance rates, the economy has an effect on the bottom line price. While there are many factors that affect our current economy, understanding the duties of the Federal Reserve can improve one’s overall knowledge of how the system works and how the steps taken by the Federal Reserve can change the economy. It may also help someone understand the thought process behind why the price of gas will not decrease or why imports and exports pricing for the United States are currently not favorable. One of the primary functions, and the original reason for establishing the Federal Reserve is to conduct the United States monetary policy by persuading economic conditions by demanding maximum employment, stable pricing, and good interest rates . Before further reviewing the monetary policy function of the Federal Reserve, a general overview of the entire bank and its functions needs to be established. The Federal Reserve is often referred to as the Central Bank of the United States. It was established by the United States Congress in 1913 to improve the economic state of the country by ensuring financial stability. Before it was established, the economic state of the United States was shaky to say the least. Congress created the National Monetary Commission to create an institution that would prevent and contain crisis in the future. Ultimately, this led to the Federal Reserve Act and then the Federal Reserve Bank. The bank was originally established to help be a financial back bone for depository institutions in times of need when widespread financial panic was on the rise. Over the years, it evolved and began participating in other functions. These include monetary policy, banking regulations, maintaining financial stability in the markets, and providing financial depository services to the government and other official foreign institutions . The deciding parties behind all of these functions include a Board of Governors, the 12 Federal Reserve banks located all over the country, the Federal Open Market Committee, and various other member banks and advisory committees. Many ask who comprises of all of these committees and boards with the recent financial crisis the United States has faced and the Federal Reserve has recently found itself in sticky situations. According to CNN Financial News Online, in an article published just recently, these committees weren’t even fully aware of the oncoming crisis until they were caught right in the middle of it when the Great Recession of 2007 began. It wasn’t until 9 months into discussing the imminent fall of the housing market and how it was going to affect the overall health of the economy that the discount rate was slashed and the federal funds rate was addressed. This was beginning of the Great Recession of 2007 and little did the Federal Reserve know that the United States would still be fighting these same issues in Spring of 2013 . The goals of the monetary policy function of the Federal Reserve are derived from the Federal Reserve act. This act was put into place when the Federal Reserve was established and outlines the goal of promoting effective goals of maximum employment, stable prices, and moderate long-term interest rates. Stable pricing is the backbone of all three of those goals. Once pricing is stabilized and inflation or price hiking is controlled, it will cost less to operate businesses and households because goods, services, and material pricing will have leveled out and everyone can then afford to purchase more. Once a level price is established, businesses can better allocate resources which include employment and investing in more methods to grow their businesses. Moderate long-term interest rates are one of the primary goals of the Federal Reserve and one of the hot topics of the country’s current economic state is also interest rates. Since the financial crisis began, this is been one of the monetary policies that has tremendously evolved. In late 2008, the Federal Reserve’s Open Market Committee established a near zero target range, called the zero lower bound, for federal funds and holds longer term securities through purchases. The goal of these actions is to limit consumers in taking out long term interest rates . Not only does this action overall improve the countries credit, but it also allows for more money to be spent on things that matter which includes jobs. If consumers and businesses have less debt over a shorter period of time, they can spend more cash on creating new positions within their companies. Another example of how lower rates have positively impacted the economy is proved in the Federal Reserve’s behavior of continuously buying mortgage-backed bonds. This is the method the Federal Reserve is using to force yields down and reduce the cost of home ownership. This has made a positive impact because now, more so than ever before, people can actually afford to purchase a home. The average rate right now for a 30-year mortgage is 3.5% which is the lowest average on record. With the lower rates in housing, everyone can afford to buy other things as well which in turn improves the economy and creates jobs . According to a Wall Street Journal article published in early May, the Federal Reserve looks to continue to purchase more bonds to ensure the interest rates stay low. This is a clear indicator that the economy is still heavily relying on the purchasing power of the central bank to ensure the economy stays afloat and doesn’t crash. If the interest rates start climbing, purchasing power becomes more limited for consumers which in turn would tighten pockets, limit spending and cause the pricing to become unstable and jobs to become limited. This recent report also indicated that until jobs picked up, the bond purchasing would continue . Market strategy professionals, finance professionals, and economists all look at one thing when measuring how the Federal Reserve is affecting the economy. As previously mentioned, the Federal Reserve Bank is the backbone of all financial institutions. It is based upon depository company accounts. Depository companies include banks, trading and investment companies, and basically anyone who has their hand in the financial services industry. These institutions trade balances at the federal funds rate and the rate is believed to improve economic conditions based upon the current objectives of the monetary policy. Changes in this rate have immediate impacts on the current state of the economy . The federal funds rate is established and maintained to assist in controlling supply and demand for balances at the reserve banks. The rate is set at a rate that is believed to meet current policy objectives and is adjusted based upon current economic situations. Any change in the rate affects households and businesses spending behaviors . If people are buying and businesses are selling, then supply and demand is growing. The monetary policy function of the Federal Reserve also has another impact outside the realm of original theory in the Federal Reserve act. Changes in monetary policy affect the value of the American Dollar. If interest rates are fluctuating then so is the value of the dollar. If the rates rise, dollar assets look more favorable and in turn investors will spend more money. Imports and exports are then affected by the value of the dollar because it will cost less to bring goods in and cost more to export goods. Ultimately, any changes in the value of any financial asset results in spending habit changes to be made. This is why the Federal Reserve tries to establish stable pricing so that the interest rate and prices do not fluctuate too much. Better business decisions can be made by consumers and business owners when prices and rates remain constant . Monetary policy within the Federal Reserve bank all transmit or directly relate to the current state of our economy. As with the economy, however, monetary policy is ever-changing. To date, there hasn’t been one method or policy that has directly tied a positive relationship with the ultimate goals of monetary policy, at least not one policy that would work if it were to stand alone . All of the different methods have to work together, as does monetary policy need to work with fiscal policy for true effectiveness in the economy. Interest rates need to remain constant so the true value of an investment can be assumed and decision can be made. From there, prices can be established and maintained as well thus resulting in job growth. One always affects the other. Determining how to establish all three positively simultaneously has proved to be more difficult in times of economic crisis for the United States.

Word Count – 1,579
Works Cited
Kurtz, A. (2013, January 18). Federal Reserve was Blind to Crisis in 2007. Retrieved May 5, 2013, from money.cnn.com: http://money.cnn.com/2013/01/18/news/economy/federal-reserve-transcripts/index.html?iid=SF_BN_River
McGrane, V. a. (2013, May 1). Fed Says Bond Purchases Could Rise or Fall. Retrieved May 5, 2013, from online.wsj.com: http://online.wsj.com/article/SB10001424127887324266904578457050528365108.html
Six Years of Low Interest Rates in Search of some Growth. (2013, April 6). Retrieved May 5, 2013, from economist.com: http://www.economist.com/news/briefing/21575773-central-banks-have-cushioned-developed-worlds-economy-difficult-period-they-have-yet
The Federal Reserve System Purposes and Functions. (2005, June). Retrieved May 5, 2013, from federalreserve.gov: http://www.federalreserve.gov/pf/pdf/pf_complete.pdf