Monetary Policy Formulation And Decision Making Simulation

One of the issues most often discussed in the United States (U. S. ) is the Iraq war and war on terrorism, but in recent times one major issue that almost always makes the headline of newspapers e. t. c. and which is of great concern to the U. S. people and government is the waning economic and financial conditions being witnessed in recent times.

I will like to use the economy of Columbia, Maryland, North Carolina, South Carolina, Virginia, and West Virginia all belonging to the Fifth district according to the Federal Reserve Bank (Fed) as a case study for analyzing the current economic conditions, forecast future prospects and simulate monetary policy-making process for the district and United states in general. The economic conditions in the fifth district is fast going into recession as evidenced by the negative reports received from almost all the sectors of their economy.

Consumer spending is characterized as softening, with declines in retail and auto sales. In contrast Tourism has been strong. On Nonfinancial Services, demand for Transportation services was generally characterized as weak, while Business and Health services continued to expand; while activity at financial services firms has been quite weak and other service industries were said to be mixed. Trend in manufacturing sector is such that Real estate and Construction were generally feeble for the Residential sector.

While an assessment of the Financial institutions indicated slowing in loan request by consumer with lending criteria becoming more stiffened, there is an up-beat in the Agricultural sector and encouragement in the Energy industry. Another important aspect of the economy is the rate of Un-employment, and this has witnessed sluggish demand for workers with requests for warehouse and distribution center workers had falling off sharply, though demand for temporary employees with computer and administrative skills remained strong.

In one word, the Economic and financial conditions of the fifth district and the U. S. in general can aptly be described as being in a contractionary stage of a business cycle (a term used by economists to designate a periodic increase and decrease in an economy’s capitalist countries has varied from high output and employment to low output and employment) which is characterized by a fall in employment, production, wages, and business profits e. t. c. such as it is being witnessed now in virtually all the sector of the economy.

Consumers react to higher prices and higher interest rates by buying less. As purchases begin to lag behind production, business firms begin to accumulate inventories (the merchandise or goods that a company or store has on hand), producers begin to cut back on investment in facilities and reduce employment and despite these adjustments, profits still fall and further cutbacks are made. The decline in housing prices, the weight of accumulated household debt, and the losses and uncertainties in the banking system threaten to push the economy into a self-reinforcing decline.

The prospects for economic activity, some particular areas have come forth of late and have increased doubt about the near-term outlook. One of this is the issue of Housing where new single-family houses were started at an average annual rate of a bit under 1. 2 million units in the first three months of this year–a pace roughly one-third below the highest unit attained 2005, and with further weakening in prices of houses in January and February this cutbacks is quite likely to persist.

But with some positive news few weeks back that demand has been fairly steady through April, the housing sector might just be on its way to picking up. Report in recent times on the rate of Un-employment is another major factor in which if not paid proper attention to is likely to go out of hand, as in the past few months there has been an enormous job shed. But with the report from Labor department stating that the job cut of the past month (April) is not as much as previous months is a good sign that the economy may soon be on its way to a much more favorable job environment.

Business investment is another major area of concern in the near-term outlook which if not well managed will cause a serious downturn. Real expenditures for new equipment and software has continued to diminish with the decline in demand for investment goods that are used heavily in residential construction a major factor responsible for the weakness. Demand for goods used by the motor vehicle industry and other types of non-high-tech business equipment also appears to have slowed recently, raising more fundamental questions about business views on the current and prospective environment for capital spending.

There is reluctance on the part of businesses to invest possibly due to concerns about the prospects for long-term productivity growth and the expected rate of return on capital investment. That is the reluctance only reflects their uncertainty about the outlook for sales and earnings. If this is anything to go by, then the continuation of a moderate economic expansion is likely over time to restore confidence and lead to a tautening in business investment. It must however be stated that even though the prospects for housing, business spending e.

t. c. appear to have widened the range of uncertainty about the near-term outlook, developments in other sectors seems encourage an unrelenting modest rate of economic and financial growth. Monthly gains in employment is still firm; the average monthly increase in nonfarm payrolls from the beginning of the year is about 150,000, compared with about 190,000 in 2006. Also, consumer spending has been consistent with a moderate pace of demand, and the steady labor market has been generating income.

On the international trade front, recent economic activity abroad have been favorable suggesting that the demand for U. S. exports of goods and services will continue to be solid. Prospects for further economic expansion abroad appear good in the near term. If left unchecked, the financial and economic decline will be self-reinforcing, with people walking away from homes in which they have negative equity and more and more financial institutions becoming insolvent, thus reinforcing both recession and flight from the dollar. This could hence lead to the following:

• Rejection of United States Dollars as payment for oil or other exports by other countries with China being one the countries that have already started. • Severe Stagflation which period of slow economic growth and high unemployment (stagnation) while prices rise (inflation), • Devaluation and collapse of the Dollar, • Fall in the stock market as a result of extreme fundamentals (company’s growth, revenues, earnings, management, and capital structure) occurring in the rest of the financial markets, Continued fall in the prices of houses,

• Bank failure, as a result of inability of Borrowers to pay back mortgage and credit card debt. Other than the economic consequences of a prolonged unfavorable economy, there are broader social consequences. This is evidenced by several studies which have shown that declines in economic activity coincide with declines in birth rates and increases in death and divorce rates. The higher unemployment rates caused by recessions are also associated with higher suicide rates and higher crime rates.

Studies conducted by an American economist Milton Friedman in a bid explaining the causes of business cycle indicated that the ‘money supply’ was the primary cause of changes in business conditions, and it has become better understood in recent years that once a logical structure for monetary policy is put in place, the regular policy decision is essentially a matter of responding to the changing balance of risks to the outlook. Monetary policy involves control of the money supply and interest rates by the central bank.

In the United States the central bank is known as the Federal Reserve System (Fed. ). The Federal Reserve System is in charge of putting checks and balances to the amount of credit available to businesses and consumers and the cost of the credit, and it is best known to the public for the influence it has on interest rates by “slackening” or “stiffening” the money supply (the amount of currency, coin, and checking account balances available at any one time in the U.

S. financial system). This U. S. Central bank can directly or indirectly influence the total money in circulation by various means, some of which are the following: • Controlling the federal funds rate which is the interest rate at which banks lend money to other banks that need to make loans. • Engaging in open market operations which is the most frequently used instrument of controlling the money supply and the federal funds rate.

• Changing the required reserve ratio which is the percentage of deposits that banks must maintain on reserve as cash deposits at the Federal Reserve banks. • Making changes in the discount rate which is the rate of interest at which the Fed lends money to banks. In addition to reinforcing open-market operations, it also has an “announcement effect,” signaling a change in the Federal Reserve’s underlying evaluation of economic conditions. • Controlling various types of consumer credit as backed by the Credit Control Act of 1969.

Since what the Fifth district and indeed the United state is experiencing now is an economy in a state of contraction where there is not enough money in circulation thus giving rise to a weak purchasing power on the part of the customer, the U. S. financial institution ought to introduce an “Expansionary monetary policies” that entails increment in the rate of growth of money supply and lowering short-term interest rates. By doing these, the Fed increases the availability of credit and lowers the cost of borrowing in an effort to stimulate the economy.

“Government intervention is necessary to protect the weak and ensure that all gain some of the benefit of economic progress”. – Tony Blair (Former British Prime minister) Aside the Federal Reserve System (which is independent of the government), the Government can also engage in direct intervention to counter a recession through the use of fiscal policies. While monetary policy involves control of the money supply and interest rates by a central bank, Fiscal policy consists of changes in government spending or taxation or both.

However, like monetary policy we also have Contractionary and Expansionary fiscal policies. If the government seeks to encourage an economic expansion just as is expected in the case of Fifth district, an Expansionary fiscal policy is introduced which involves the following actions: increase in purchases of goods and services, increase in social service spending and subsidies, or reductions in taxes, all in an effort to stimulate production and employment.

In line with its dual responsibility to encourage maximum employment and price stability, the Federal Reserve System must continue to react aggressively to shocks that have potentially persistent adverse effects on both inflation and real activity. And in this current economic and financial condition it should add liquidity to credit markets and increase the size of some cash auctions for financial institutions.


1. Speech at the Levy Economics Institute of Bard College (April 20, 2007) Annandale-on-Hudson, New YorkGovernor Frederic S. Mishkin , 2. Monetary Policy Review (2007) Frank J. Bonello (Microsoft Encarta) 3. “The Credit Crisis” (2008) George Soros