The Federal Reserve System

The first tool that the Federal Reserve System uses to influence and/or control the money supply of the U. S is open market operations. Open market operations put money in and take money out of the banking system. This is done through the sale and purchase of U. S. treasury securities. When the U. S. sells securities, it gets money from the banks and the banks get a piece of paper that is basically an I. O. U that says the U. S government owes the bank the money. This drains money from the bank. The process is repeated when the government buys securities.

In this case the government gives the banks money and the banks give back the I. O. U to the government. In this way money comes back into the banks (Miller, 1997). The second tool that the Federal Reserve System uses to influence and/or control the money supply of the U. S has two parts: the federal funds rate and the discount rate. The Federal Reserve System uses monetary policy largely by targeting the federal funds rate. This is the rate that banks charge one another for overnight loans of federal funds which are the reserves held by banks at the Federal Reserve.

The federal funds rate is determined by the market and is not explicitly mandated by the Federal Reserve System. The Federal Reserve does by aligning the effective funds rate with the targeted rate by adding or subtracting from the money supply through the open market operations. The Federal Reserve System also sets the discount rate. The discount rate is the interest rate that is charged to commercial banks and other depository institutions on loans that they receive from their regional Federal Reserve Bank’s lending facility, the discount window.

Discount window lending are overnight loans that members banks borrow directly from the Federal Reserve System. This rate is generally set at a rate close to 100 points above the federal funds rate. The idea behind the discount rate is to encourage banks to seek alternative funding before they utilize the discount rate option (Miller, 1997). The third tool that the Federal Reserve System uses to influence and/or control the money supply of the U. S. is reserve requirements. Reserve requirements, also called required reserve ratio, are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities.

In other words, reserve requirements set the balance that the Federal Reserve System requires a depository institution, such as the banks that are in the Federal Reserve System, to hold in the Federal Reserve Banks. These depository institutions then trade in the federal markets that are utilized by the Federal Reserve System. The reserve requirements are set by the Board of Governors of the Federal Reserve System (Miller, 1997). The fourth tool that the Federal Reserve System uses to influence and/or control the money supply of the U. S.

is a host of new programs and tools that have been implemented in the last few years to address problems that are related to the subprime mortgage crisis and the U. S. housing bubble. The first new tool, term auction facility, was created on December 12, 2007. At first it was only going to be a temporary tool that would be at the disposal of the Federal Reserve System, but now thee have been many suggestions that it be made a more temporary tool. The term auction facility is a program in which the Federal Reserve auctions term funds to depository institutions.

It was created because banks were not lending funds to one another and banks in need of funds were refusing to use the discount window. Banks were not lending money to one another because each bank feared the money would not be paid back and banks did not utilize the discount window because using the discount is often associated with the stigma of bank failure. With the creation of the term auction facility, the identity of banks that are in need of funds is protected in order to avoid the stigma of bank failure. A second new tool was created and announced on March 11, 2008, the term securities lending facility.

Unlike the term auction facility (which was created to inject cash into the Federal Reserve System), the term securities lending facility is used to inject treasury securities into the banking system. The term securities lending facility is a 28-day facility that offers treasury general collateral to the Federal Reserve Bank of New York’s primary dealers in exchange for other program-eligible collateral. It is intended to promote liquidity in the financial markets for the treasury and other collateral in order to foster the functioning of financial markets in general.

A third tool was created and announced on March 16, 2008, the primary dealer credit facility (PDCF). This new tool was a fundamental change in Federal Reserve policy because not the Federal Reserve is able to lend directly to primary dealers which has always been not mandated by the Federal Reserve System. The PDCF is an overnight loan facility that provides funding to primary dealers in exchange for a specified range of eligible collateral and is intended to foster the functioning of financial markets in general (Miller, 1997).

8. Fiscal policy is the government’s attempts to influence the direction of the economy through changes in government taxes or through some spending, also known as fiscal allowances. Fiscal policy concerns itself with the overall effect of the budget outcome on economic activity which is in stark contrast to monetary policy which attempts to stabilize the economy by controlling interest rates and the supply of money. The two tools of fiscal policy that can affect the macro economy are government spending and taxation.

The changes in the level and composition of both taxation and government spending can impact numerous variables of the economy of a country. One very good example of how both government and taxation can affect an economy is by looking at the aggregate demand and the level of economic activity. Governments can influence the level of aggregate demand in an economy by using both taxation and government spending. A government would choose to use both taxation and government spending to do this in an effort to achieve the objectives of price stability, full employment, and economic growth.

According to Keynesian economics, adjusting the amount a government spends and the taxation rates are the best ways to stimulate aggregate demand. During periods of economic growth, a budget surplus can be used to decrease activity in the economy. A budget surplus would be used by the economy of a country if inflation is high in order to achieve the objective of price stability (Miller, 1997). There are three types of fiscal policy that utilizing both government spending and taxation to affect the macro economy: neutral stance fiscal policy, expansionary stance fiscal policy and contractionary stance fiscal policy.

In neutral stance fiscal policy there is an implied balanced budget government spending and tax revenue are equal. In other words, government spending is fully funded by tax revenue and the overall budget outcome has a neutral effect on the level of economic activity. In expansionary stance fiscal policy there is a net increase in government spending through a rise in government spending or a fall in taxation revenue or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus then the government previously had or if the government already had a balanced budget it will lead to a deficit.

This type of fiscal policy is almost always associated with a budget deficit. In contractionary fiscal policy net government spending is reduced through either higher taxation revenue or reduced government spending or through a combination of the two. This kind of fiscal policy would lead to a lower budget deficit or a larger surplus than the government had before. It could also lead to a surplus if the government previously had a balanced budget. This kind of fiscal policy is most often associated with a budget surplus (Miller, 1997). But it should be remembered that making use of fiscal policy can be a double edged sword.

When governments are running a budget deficit, funds will need to come from borrowing in the form of the issuance of government bonds, overseas borrowing or printing of new money. When governments fund a budget deficit such as this with the release of government bonds an increase in interest rates across the market can happen. This basically happens because government borrowing creates higher demand for credit in the financial markets which in turn causes a lower aggregate demand due to the lack of disposable income, a concept that is called crowding out.

Governments do have a second alternative; they can increase government spending by funding major construction projects. This can also cause crowding out because of the lost opportunity for private investors to undertake the same project. Another problem that there is associated with fiscal policy is the time lag between the implementation of the policy and the detectable effects of that policy on the economy. Unfortunately, it takes time for policies to be put into place and then for any effects of that policy to be seen on the economy in measurable units (Miller 1997).