The Federal Reserve is the main monetary institution in the United States. As such it has the enormous task of ensuring that the money supply in the economy is at a steady rate and it does this by implementing certain fiscal policies and controlling interest rates. This discourse therefore will seek to discuss the effects of interest rate hikes and inflation on the economy and how these factors affect the economy and the policy formulation and implementation of the Federal Reserve. This will also include a brief discussion of the three main tools of monetary policy that the Federal Reserve uses to achieve its objectives.
Monetary Policy Tools
The main monetary policy tools of the Federal Reserve consist of open market operations, reserve requirements and discount window lending. Open market operations is the most important tool because it allows the Federal Reserve to directly control the money supply. The buying and selling of government securities and bonds increases or decreases the funds that are available in the market, therefore, directly affecting the interest rates (Epstein 273).
Reserve requirements are another effective tool because regulate the amount of money that banks are required to keep on hand. The more money that is required to be reserved the less capital is available in the market (Epstein 273). This leads to higher interest rates but at the same time serves to counteract the effects of inflation.
The last tool that the Federal Reserve uses is the discount window lending tool which determines the rate by which banks are able to borrow from the Federal Reserve. This can be seen through the diagram added below:
Discount RateRaisedLoweredImpact on Economic ActivitySlows economic activityStimulates economic activityPolicyCheck inflationEconomic growth
Effect of Interest Rates on the Economy
Interest rates affect the economy by determining the rate of investments. Any increase in the interest rates causes a decrease in the level of investments due to the fact that it means that a higher amount has to be paid for every unit of currency borrowed. This is not a negative effect however because rising interest rates usually mean that the economy is growing and that there is a need to increase interest rates to control or decrease the money supply available to counter inflation (Baumol, 206).
The effect of the interest rate in the economy and on money supply can be explained in simple supply and demand terms. When the economy is growing, there is a need for more capital to fund investments and capital expansion. This increase in demand also causes a corresponding increase in the rates because people are now willing to borrow money at higher interest rates as opposed to when the economy is in a slump (Baumol, 206). The concern of the Federal Reserve in this matter, which will be discussed in the later section, is that this could lead to an oversupply of money causing sharp inflation within the economy.
Effect of Inflation on the Economy
Inflation is said to occur when there is an oversupply of money causing the prices of goods to react accordingly in relation to the amount of increase and the relative wage rate of individuals (Baumol, 206). There are two (2) main schools of thought regarding the causes of inflation and these are the quality theories of inflation and quantity theories of inflation. The quality theories generally assert that as a result of pressures in the economy the prices of commodities increase. The quantity theory on the other hand postulates that inflation is determined by equations with regard to money supply; its velocity and exchanges.
The other theory on the cause of inflation is based on the law of supply and demand in that the more disposable income people have as caused by higher wages, the greater the demand for items thus allowing suppliers to raise prices for the items that they are selling (Baumol, 206). This is consistent with the theory of Abraham Maslow on the hierarchy of needs which states that as wage increases, the disposable income for the other items increases since the level of need for basic necessities remains at a fairly constant level (Mishkin, 195). This is basically an adaptation of the demand-pull theory of inflation in that there is a higher demand for goods in relation to employment and wages.
There are many effects that inflation has on an economy such as Relative Price Distortions, Imbalance of trade, Slower Investment and Lower Spending. One of these effects is on money supply, which will be discussed in the next section.
Financial Policies of the Federal Reserve
The Federal Reserve is a quasi-banking institution that basically oversees the welfare of the economy and set monetary policies to encourage economic growth (Epstein 273). The Federal Reserve is also able to control the growth rate of the local economy by controlling the money supply.
As discussed in the previous section, the interest of the Federal Reserve with regard to interest rates and inflation is simply due to the close relationship between interest rates and inflation to the money supply which greatly affects the foreign exchange rate of the dollar and economic growth (Epstein 273).
By controlling short-term interest rates, the Federal Reserve is able to influence interest rates in general because of its size. The Federal Reserve can also do this by controlling the open market operations by increasing the federal funds rate, which is the rate that banks charge on loans from other financial institutions for funds that originate from the federal funds (Baker, 205).
Thus by expanding or contracting the money supply by manipulating the exchange rates, the Federal Reserve is able to effectively combat any inflation that may occur and also regulate the value of the local currency in the foreign exchange market. This also results in more favorable balances in trade.
The concern of the Federal Reserve with regard to inflation can be stated in this manner. Inflation can be one of two things for the Federal Reserve, it can be a cause or it can be an effect, indicating certain changes within the economy (Baker 205).
As a cause, inflation concerns the Federal Reserve because it can be an indicator that there is a growth stimulus in the economy and it warns the Federal Reserve that it must influence the money supply by increasing interest rates (Baker 205). As an effect, it tells the Federal Reserve that the economy is in recession and must react accordingly.
These two factors therefore greatly affect the monetary policies that the Federal Reserve implements in controlling the money supply.
The current economic crisis that has rocked the global economy has prompted many countries to take drastic measures in order to deal with the situation. The Federal Reserve and the National Treasury have also teamed up to deal with this global economic crisis by instituting several reforms and policy changes. With the goal of providing an immediate and permanent solution to the problem, the Treasury, with the help of the Federal Reserve, has instituted these five fiscal policies to alleviate the situation.
One of these policies is the voluntary capital purchase program. It is aimed at selling preferred shares of stock to the United States Government on favorable terms that afford the maximum amount of protection to the taxpayer (Baumol 33). Another policy that has been implemented is the systematic risk exception under the FDIC Act which grants the FDIC the power to guarantee, on a temporary basis, the senior debt of all FDIC insured institutions (Baumol 33). The third policy that has been announced is the increased access to funding for all of the businesses in various sectors of the American economy (Baumol 33). The goal of this is to stimulate economic growth on a micro level in order to develop solid economic fundamentals that can help resuscitate the economy.
Other steps that the Federal Reserve and the National Treasury have taken include the strengthening of capital position and funding ability of American Financial Institutions. These are to be achieved through multilateral agreements such as the reciprocal currency arrangement (Swap Lines) with International Central Banks (Baker 205). Finally, the heralded US $700 billion bailout plan that was recently enacted into law has also been designed to infuse much needed capital into the market and to protect the exposure of several multinational and local financial institutions (Baker 205).
Despite all of these moves by the Federal Reserve and the National Treasury, however, it still remains to be seen whether or not these “quick fixes” can actually provide real and lasting solutions that have been caused by poor economic fundamentals.
The direct relationship that interest rates, inflation and even higher wages have on the amount of money supply is a matter of importance for the Federal Reserve because as shown in this study, and change in these factors could increase or decrease the money supply and adversely affect the economy of the United States. The key for the Federal Reserve then remains in being able to closely monitor these factors and be able to anticipate any sudden changes and react accordingly by utilizing the many tools that are at their disposal.
Baker, D. (2005). The Federal Reserve Board – The Most Important Source of Poverty in the United States Center for Economic and Policy Research Economics Seminar Series.
Baumol, W. and Blinder, A. (2006) Macroeconomics: Principles and Policy, Tenth edition. Thomson South-Western, United States
Epstein, L. and Martin, P. (2003). The Complete Idiot’s Guide to the Federal Reserve. Alpha Books. United States
Mishkin, F. (1995) The Economics of Money, Banking, and Financial Markets, New York, Harper Collins. United States.
Meltzer, Allan H. (2004) A History of the Federal Reserve, Volume 1: 1913-1951 the standard scholarly history