Introduction Most people say that looking in the past you can see the future, with economics this is true. With the economy in the state that it is in, people will be wondering what they should do and more importantly not do. At the Bank of Green we strive to be the best at what we do and many have voiced their uncertainty about the economy and where it is headed. This report will show you what is happening in the economy and what will most likely happen this coming year. The Federal Reserve still has not met to discuss this but there is a likely course of action that they will take, I will account for this uncertainty.
After reading this you should be able to fully understand the future of the economy and more importantly explain what is happening to your customers so they know that they have someone who knows what they are doing behind them. I will be going over the forecast for 2006 with projected quarterly growth rates and what they mean, as well as the rate of inflation for 2006. Along with that we must consider the action the Federal Reserve will take along with how they achieve their goal. The Federal Reserve The Federal Reserve System, often called the Federal Reserve or simply put as The Fed, is the central banking system of the United States.
Founded in 1913 by the Federal Reserve Act in response to major financial panics, The Fed has assumed more responsibilities and evolved into a regulatory super bank. Its major duties include but are not limited to; creating monetary policies, supervising and regulating banking institutions and maintaining the stability of the financial system. Today we treat The Fed as a financial guru for when the economic stability of our country seems unusual. The Money Supply The money stock, or more commonly known as the money supply, is the total amount of money available in an economy at a particular point in time.
The money supply usually includes currency in circulation and the funds held in demand deposit accounts in commercial banks such as ours. The money supply is very important because of its strong link with inflation. An early 20th century economist Irving Fisher created and explanation for their link. It was coined the Equation of Exchange which said that the total dollars in a country’s money supply multiplied by the number of dollars spent each year will equal the average price of all goods and services sold during the year multiplied with the quantity of assets sold during the year. The Federal Reserve’s Effects on Money Supply.
The Equation of Exchange or the similar macroeconomic Equations for the Demand of Money both are good at showing a link between money supply and inflation, but do not help with economic predictability. This made The Fed rely less on only money supply and more on inflation in order to steer the U. S. economy. In order to adjust inflation The Fed must use its tools to change the money supply accordingly. The three most regularly used processes that The Fed undertakes to change the money supply are Open Market Operations, making changes in the Reserve Requirement and making changes in the Discount Rate.
The Fed can adjust the money supply by three things; 1. Open Market Operations a. Buying Bonds i. Raises the money supply b. Selling Bonds ii. Lowers the money supply 2. Changing Reserve Requirements c. Raising limit affecting the amount banks can loan out iii. Lower money supply d. Lowering limit affecting the amount banks can loan out iv. Raise money supply 3. Changing the Discount Rate e. Higher Rate v. Lower the bank’s willingness to lend money, lowering the supply f. Lower Rate vi. Raise the bank’s willingness to lend money, raising the money supply
Open Market Operations and its Effects on Interest Open Market Operations include selling and buying government securities or other financial instruments. When there is an increase in demand for the amount of money in a country The Fed goes to the open market to buy assets like bonds, foreign currency or commodities (i. e. gold and silver). To pay for these assets they print more cash which is eventually transferred to the seller’s bank and the amount of money in the country is now higher. The reverse scenario would be The Fed selling their financial instruments to the open market.
This results in The Fed obtaining money from the buyer and removing that cash value from the economy. These adjustments to the total supply of money in an economy have a direct effect on interest rates. Inflation and interest rates usually tend to be inversely related. The Fed will target and expected inflation rate that they aim for by adjusting the interest rate. If The Fed raises interest rates, inflation is reduced and if The Fed lowers interest rates then inflation increases over time. Reserve Requirement and its Effects on Interest
The Federal Reserve, acting as the nation’s central bank, sets regulations for commercial banks. It directly determines the minimum reserve of funds, deposits and notes that commercial banks must hold rather than lend out at a given point in time. This regulation is used as a tool of monetary policy. By adjusting the reserve ratio, the amounts of loans available are affected. With a lowered Reserve Requirement, more of the commercial banks money may be used for loans. This pushes for lower interest rates because of the increase in loan supply. With a higher Reserve Requirement, the commercial banks are restricted to fewer loans.
This results in higher loan demand which increased the interest rate per loan, simultaneously allowing the banks to balance their revenue. Discount Rate and its Effects on Interest The Discount Rate is the interest rate that The Federal Reserve charges commercial banks for borrowing reserves. Changing the Discount Rate does not directly affect the money supply but is an effective tool for providing liquidity in a case of emergency. With a lowered Discount Rate, commercial banks will be more inclined to borrow from The Fed, and provide funds for the banks transactions.
The Discount Rate inadvertently affects the money supply by the banks willingness to loan out money and not hold it. By banks loaning more money they put more money into the economy and vice versa. Current Economic Problem As many of you know the economy is starting a recession if the Federal Reserve does not take action. Based on the average percent change of both nominal and real GDP for the years 1990-2005, which are 1. 284553% and 0. 731661% respectively, and the nominal and real GPD of this coming up year of 2006, which is -1. 40274% and -2. 56263% respectively, shows a large decrease in both.
From now on we will only be talking about real GDP. Nominal GDP is the market value of goods and services for a country. Real GDP is a measure of output for an economy and it is adjusted for price changes which makes it an index for quantity of total output. Thus making real GDP more efficient when tracking economic output over a period of time being that they are all related to each other. With a 3. 294291% change in the last twenty years and a fall of 0. 603848% change from the third and fourth quarter of 2005 can cause most investors to fear what is happening next. Since we have passed the first quarter for 2006, the real GDP of 1.
30153, which is an increase of 0. 8909% change from the last quarter. Such a large increase is usually followed by a large drop as in 2003 in the quarters three and four and in 1996 in quarters two and three. With the GDP price deflator going up means that interest is also going up. From quarter four of 2005 and quarter one of 2006 we see that there was a 0. 008130% increase in inflation, which may seem small but it also signifies slow growth. Slow growth can lead to unemployment and cause other problems similar to that, which is why most investors are worried. The projected inflation rate for 2006 is 0.
012016, which is a lot higher than the 1990-2005 period, which is 0. 005494. Looking to the prospected real GDP growth can also lead to worries. The year 2006 in real GDP is 11,394. 7, 10,786. 2, 10,333. 5, and 10,125. 3 in billions of dollars. This is year has an average total of -2. 56263% decrease in real GDP if the Federal Reserve does not do anything to stop it. The total of these three things can and will cause your investors to worry what is coming next. | Percent Change of Nominal GDP| Percent Change of Real GDP| Average GDP Deflator| Inflation: Percent Change of GDP Deflator| 1990-2005| 1.
284553| 0. 731661| 96. 30224894| 0. 005494| 2006| -1. 40274| -2. 56263| 117. 0838007| 0. 012016| GDP Data From 1990-2006 How the Federal Reserve Will Act If the Federal Reserve was to take action they will start with their open market operations. They will first start to sell bonds on the open market to take more money off of the street directly influencing the amount of money on the streets. This will raise interest rates and take more money off of the streets. To understand this we must look to see what is happening in the economy. The type of inflation that we are experiencing is Demand-Pull Inflation.
Demand-Pull Inflation is when there is an increase in aggregate demand, which is the quantity of goods and services that firms, households, and the government want to buy at all price levels. Demand-Pull Inflation is caused by having more money than there is to buy items, which cause people to demand more at a higher price, like bidding. Because this inflation increases aggregate demand, as shown in the graph, thusly causing price and real output to also increase to a new equilibrium. By having the aggregate demand increase it also increases the amount of output that companies want to achieve.
In other terms, by having more money, the items become more valuable compared to the money causing you to need more money to purchase items than before. They companies want to capitalize on this increase in cost and will make more items. The Fed wants to plateau out at a safe level and at the first sight of inflation they will take precautionary measures to stop it. They will do this by affecting the interest rates and since it is not a very large increase they will only sell bonds to take some of the money off of the street. [email protected] [email protected]
Aggregate Demand Increasing Federal Reserve Policy and Inflation Many people believe that changes in the Federal Reserve policy can affect inflation, with the regression line equation being Y = 0. 13586408 + 056731152X and substituting values for X we can see how it responds. There is a 0. 56731152 difference from each whole number of X indicating that the amount of money does play a role in inflation. The coefficient of determination, R squared, is 0. 3258977, which means that there is a 32. 58% chance that this data is connected.
In statistical hypothesis testing, the p-value is the probability of obtaining a test statistic at least as extreme as the one that was actually observed, assuming that the null hypothesis is true. With the P-value of 0. 962854, we can assume that there will be a high error when trying to determine what the future holds for inflation. Faster money growth is not always associated with inflation or vice versa. As seen in the graph below we can assume that there is no absolute correlation between money and inflation. Increases in Money and Inflation in Five Year Periods
On the other hand we can look at the points with a polynomial function rather than a regular line. With an equation of Y=-0. 0096X4+0. 4048X3-5. 4467X2+27. 946x-40. 051 with an R-squared of 0. 9198. This gives us a better flow of the data points with the trend line. With a R-squared of 0. 9198 shows that we have a better probability and as you will see in the graph it will also show the ups and downs that the economy takes regularly. With a Polynomial Trend Line Bank of Green Customers As those who stay current with the news can confirm, there has been a lot of talk about a slowing economy.
It is generally accepted for an economy to hit an occasional “road bump” and because of that it is expected for us at Bank of Green to prepare ourselves and our loyal customers for the possibility of an economic downfall. The Federal Reserve’s Role in a Declining Economy The Fed would have to focus on solving both long-run and short-run issues. In order to calm the panic of an expected recession the first focus would be changing the short-run economic problems by easing up on interest rates. Lower interest rates generally stimulate employment and growth in the short run.
The Fed has to be careful because unbalanced lowered interest rates may cause long-run inflation costs. In order to achieve a stable economy a healthy balance between long-run and short-run interests must be met. Pensions and Retirement Plans With inflation possibly rising in the near future, many of our long term retirees have questioned how their pensions or retirement plans will be affected. If the money supply is changed where inflation in the long-run is increased, then the purchasing value of each dollar in a pension is now less. This results in a less accommodating income for a retiree’s lifestyle.
If The Fed increases interest rates to improve the short-run economy, it would be wise for retirement funds to be diversified into investments. By investing in several stable bank or government related interest accounts, retirement funds can have a stable but gradual gain in capital, allowing for a more accommodating future. If time is limited then high profit and risk yielding investments such as stocks might be appealing because of their lowered worth. More stock can be purchased for less money. The risk accompanied with the investment may be a discouraging factor and therefor stock investments should be handled with care.
The Stock Market The stock market is heavily influenced by consumers’ confidence and spending along with the discount rate and the interest rate. If consumers refrain from spending, then there are fewer investments which in return provide less business less capital from stocks. Firms then respond with employee layoffs and reducing production to meet the lack of purchasing and capital. What does this mean for the common stock investor? Well, the stock market will fluctuate drastically depending on The Federal Reserve’s actions. If The Fed reduced the discount rate then interest rates will go down.
Money will be cheaper and more people will borrow money for possible investments, such as the stock market. This influx of investment will result in higher stock prices. It is recommended that The Federal Reserve’s actions be carefully observed when investing in the stock market. That will allow for more educated decisions for when to buy and sell stocks. The Consumers A lack of consumer confidence is a dangerous trend that can ruin an economy. The confidence of the nation is measured in the Consumer Confidence Index (CCI) which is issued monthly by The Conference Board.
Although the index is based off a 5,000 household sample it is used as a representation of the average consumer’s opinion on spending and investing. Along with other indexes, we can determine how consumers feel about current success and long term success, which is important information for The Federal Reserve’s decision making. In such times it is recommended that consumers reduce spending and increase saving. Refraining from high risk investments would be important given the unpredictability of the stock market and the economy.
Insuring stability in your work and income will help given the possibility of employment reduction. By stimulating the economy consumer confidence will be restored resulting in an increase in consumer spending and investment. Conclusion With the Fed most likely going to act on this data, this means that the Bank of Green customers will endure the rise of interest rates. With the future forecast looking towards a rise in inflation, the Fed will act in their open market operations, then the discount rate, and finally but not likely unless it is absolutely needed, changing the reserve requirements.
The data has only a 32. 58977% that inflation has any correlation to the money supply. But mainly that the Fed will act due to the increase in inflation and that will cause our interest rates to rise. New customers will be harder to come by and current customers will have to be reassured that their money is safe with the Bank of Greek and that we will help them through any problem that arises. In conclusion, the problem will be ensuring that our customers money is safe and reassure them that it is to not ensue a panic, which could have disastrous effects.