Monetary policies are the actions undertaken by the Federal Reserve System (Fed) to regulate the size and rate of monetary supply in an effort to maintain a stable economy with sufficient employment and minimum inflation (Martin, 2001). 1. Identify at least three problems facing the FED in achieving its goals of monetary policy and give your recommendations on how to deal with each of the problems you list. Monetary policy has its own limitations which act to hinder Fed from achieving its goals. Some of the limitations are;
a) Timing difficulties, there usually is a conflict in deciding which goal should take precedence at what time. To counter this limitation Fed can basically study the economic indicators to determine which direction the economy is headed. Fed can then choose what action to take, that is, whether to increase or decrease money supply. (Madura, 2008). Fed could also choose to have a policy goal of long run price stability as opposed to the short term goals. b) Lagged effects. This is the difference between the moment that an economic crisis occurs and the time a monetary policy implementation bears results.
There are three types of lags involved, (i) Recognition lag, defined as lag time between the onset of an economic setback and its detection, (ii) Implementation lag, this the holdup time between the time a crisis is detected and the time Fed implements a monetary policy. (iii) Impact lag, the lag time between implementation of a policy and the time the policy takes effect. To counter this effects, fed should implement a system that observes and reports on economic conditions regularly. Any fluctuations in the economy should be looked into critically instead of creating a widow period of observation.
c) Inability to control employment, inflation and economic growth directly. There is an inverse relationship between employment and inflation thus it would be hard to control both problems simultaneously. They both affect economic growth, when inflation is high economic growth is decreased as consumer purchasing power is reduced and the reverse is also true. This can be affected indirectly by use of open market operations, control of reserve requirements, and adjustments of discount rates. Fed can counter this by modifying money supply growth occasionally to adjust the economy.
2. Identify and explain at least three ways that the Federal Reserve affects the banking system through open market operations (OMO). This is the buying or selling of government bonds and Treasury securities in an attempt to stabilize the economy. a) Volume of loanable items. If the Fed want to increase the amount in the reserves it purchases financial assets which reduce the amount of assets the banks can trade with. Thus, banks will have fewer reserves for loans meaning increased rates on loans and hence low money supply. b) Growth.
When the Fed trades with the assets and reduces reserve supplies the bank growth in terms of expansion are stunted. Firms are motivated to borrow more if interest rates are low and demand for loanable assets slopes negatively. c) Interest rates. Fed has a mandate to control interest rates; they do this by determining the discount rate of it member banks who in turn charge other depository institutions a charge that is slightly higher than the discount rate. In this case banks are forced to raise the interest rates on loans given to their customers this lowers money supply and lowers profits attainable by banks.
3. Explain how changes in reserve requirements and the discount rate affect the operations of banks and other depository institutions. There are rules set by fed on the amount that banks should have in their reserves as backup for their deposits. If Fed lowers the reserve requirements, an increased money supply is achieved. A high reserve requirement on the other hand lowers the achievable money supply. Changes in reserve requirements affect the lending activity; when reserve requirements are raised banks have fewer reserves for loaning.
If the requirements are lowered banks get more reserves available for lending. A change in the lending activity in turn affects creation of checkable deposits which are a vital element of money supply. When loanable items are low, deposits reduce which translates to a decreased money supply. More loans will increase deposits which mean an increased money supply. Interest rates are rates that banks and eligible financial institutions are charged to borrow reserves from the fed on a short term basis. If fed raises the interest rates banks will retaliate by increasing their lending rates.
If banks loan out more items the interests rate will fall and if they are willing to loan less items interest rates are bound to go up. Fed has the power to adjust rates charged on reserves borrowed by banks. If it lowers the rates banks can borrow more reserves which they use to make more loans a lower interest rates, which means an increased money supply. If fed raises the interest rates bank are only able to borrow few reserves to make less loans at high rates thus low money supply (Martin, 2001). 4.
Explain why the FED cannot set intermediate targets in terms of both monetary aggregates and interest rates? Monetary aggregates are a policy in money supply while interest rate is a policy of a stable rate. If monetary aggregates grow too fast interests rates will go down which might trigger inflation fears and fed would be forced to raise interest rates to counter the effect. In order to achieve a stable money supply the interest rate would have to vary, if fed was to increase the money supply interest rates will automatically go down.
To have a stable interest rate money supply would fluctuate, if fed increases interest rates, amount of money pumped into the economy (money supply) will reduce and if interest rates are reduced money supply increases. The two intermediate targets cannot work together because they have counter effects. References Greider, W. (1987). How the Federal Reserve operates. NY: Simon and Schuster, 1987. Madura, J. (2008) ed. Financial institutions. US: Thomson. Martin, M. (2001). The Fed: The Inside Story. New York: Free Press. Woodward, B. (2000). Fed and the American Boom. NY: Simon and Schuster.