Identify at least three problems facing the FED in achieving its goals of monetary policies and give your recommendation on how to deal with each of the problems you list. Various problems faced by the FED in achieving its monetary policy goals are: 1) Achieving one of the monetary policy goals may affect another of its goal negatively. For e. g. creating a price stability in the economy and having a steady growth rate in the economy are two interests of the FED which clash with each other. A higher rate of economic growth may come with high interest rates.
2) The FED’s tools don’t always allow it to achieve its monetary policy goals directly. The tools can have an indirect effect on employment, economic growth and inflation rate but the FED does not control these variables directly. 3) Another challenge faced by the FED is that of timing. There are various time lags in monetary policy. Most importantly it is the lag in knowing the exact effect of a monetary policy measure taken by the FED. This happens because the FED cannot affect the variables it wants to influence directly and hence there is an information lag here. There are ways in which the FED can overcome these challenges.
Firstly they have to choose among the various conflicting interests. They need to give priority to those variables which are the need of the hour. For e. g. if the employment rate is more important, the FED may have to compromise with unstable interest rates. They can also use targets which are variables the FED can influence directly which can help achieve its monetary policy goals for variables that it cannot control directly. These targets should also be controllable and responsive to Federal Reserve’s monetary policy measures. These targets should also be measurable in a short time frame so as to overcome the information lag.
2. Identify and explain at least three ways that the Federal Reserve affects the banking system through open market operations (OMO) The Federal Reserve’s open market operations tool of monetary policy affects the banking system. Open market operations are nothing but buying and selling of securities by the FED to influence the interest rate and the growth of money and credit in the economy. Say if the FED buys the securities in the open market, they will pay for this transaction by crediting the reserve accounts of the banks involved with the sale. This means an increase in the volume of the banks’ deposits.
The FED will buy the securities in the open market when it is following an expansionary monetary policy. They will sell the securities in case of a tight credit policy. This will reduce the volume and growth of the banks’ deposits. Another affect of open market operations on the banking system is the volume of lending and interest rates attached to bank borrowings and loans. In case of a tight credit policy (selling of securities), the banking system is left with lesser reserves to lend, their interest rates rise which in turn reduces their volume of lending as a high interest rate will discourage the people from borrowing.
The volume of lending will rise if the FED is following an expansionary policy (buying of securities). More amounts of reserves will lead to a decrease in the interest rates of bank borrowings and loans. The third effect of it will be on the value of the bank stock. If the volume of the sales of the bank stock is too high, it will result in the decrease in the value of the bank stock and vice versa. 3. Explain how changes in reserve requirements and the discount rate affect the operations of banks and other depository institutions.
Changes in the reserve requirements and discount rates both affect the operations of banks and other depository institutions. The financial institutions should keep a certain percentage of their deposits as reserve account balances with the FED. An increase in the reserve requirement percentage will mean that the credit giving capacity of the institutions will decrease. Thus the FED can use reserve requirements as a monetary policy tool. For e. g.
in situations of high inflation, the FED can increase its reserve requirements which in turn will reduce the lending reserves of the financial institutions, increasing the interest rates and thus reducing the money supply in the economy(which effectively means reduced rate of inflation). A decrease in the reserve requirements will increase the lending capacity of the financial institutions which will reduce the interest rates and pump in liquidity in the economy. The depository institutions use their reserve accounts to process various financial transactions as well through the Federal Reserve for e.
g. check and electronic payments, currency and coin services. Similarly an increase (decrease) in the discount rate may lead to decrease (increase) in the lending operations of the banks and other depository institutions. In case of an expansionary policy followed by the Federal Reserve, a reduction in the discount rates will encourage the financial institutions to borrow money from them. With larger amount of reserves, the banks can then lend more which in turn will increase the investments in the economy. The reverse will happen in case of a tight monetary policy.
Since the reserve requirements and discount rate effect bank and depository institution’s operations directly, these prove to be an effective monetary policy tool for the Federal Reserve. 4. Explain why the FED cannot set intermediate targets in terms of both monetary aggregates and interest rates. The FED cannot set intermediate targets in terms of both monetary aggregates and interest rates. One of the problems with interest rates as intermediate targets is that the FED’s influence over real interest rates is weaker than its influence over nominal interest rates.
The nominal interest rate does not represent a realistic number. Real interest rate is nothing but nominal interest rate minus the expected rate of inflation. Real interest rate is the rate adjusted to remove the effects of inflation. The FED is the sole supplier of reserves in the economy and hence it can set the nominal funds rate. Even though the future expected inflation is closely related to the FED’s policies, but they can’t directly influence the real interest rates as they cannot set inflation expectations directly.
Another problem with regard to setting intermediate target is that a FED policy to stabilize interest rates may be inconsistent with the FED’s goal of maintaining steady economic growth. A high interest rate will discourage people to borrow funds from the financial institutions which will mean decrease in investment in the economy. Such a trend will reduce the rate of economic growth in the economy. Whereas if they are targeting a steady economic growth rate, it will require increasing and regular money supply in the economy which eventually may lead to very low interest rates.
If the FED sets an intermediate target for monetary aggregates, it may be conflicting with their other monetary policy objectives. Hence the FED has to choose between the intermediate target of monetary aggregate and interest rates. Both of them together are not achievable. 5. Update the case information by using at least two (2) data sources in addition to the text. Federal Reserve has a very complex structure as its functions are over – viewed and their objectives tried to be influenced by the short term objectives of the politicians. The FED has the liberty and responsibility of making the monetary policies.
It still has to get approval of the Congress on its policies but there are various institutional features which makes it independent to a certain extent from the political process. Apart from the monetary policy tools like reserve requirements, open market operations and discount rate, other policy tools available with the federal reserve are interest on required reserve balances and excess balances, term auction facility, primary dealer credit facility, term securities lending facility etc. through which they achieve their monetary goals.
The other important functions of the Federal Reserve are to act as a banker’s bank, the government’s bank, regulator and supervisor of other banks. The basic goals of all these functions remain the same which are - to promote sustainable growth and to high levels of employment and stability of prices. The main indicators of monetary policy are money supply, growth and market interest rates (mainly the federal fund rate). That is why it is necessary to set intermediate targets in these terms only so as to get the clear idea of the effect of the monetary policy changes in the economy.
But off late it has been seen that the monetary aggregates though yield some valuable information, dependable information on the position of monetary policy cannot be obtained through the same and hence interest rates are used to serve this purpose best; especially the movements in the federal funds rate. The monetary policies of the FED are an important part of the overall economic system of the US. It is playing an important part in the recent recession scenario where the FED is following an expansionary monetary policy and it has been able to recover the economy to a considerable extent.