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Date sent: Tue, 14 May 1996 16:58:37 -0700 <A HREF="X.TXT">X.TXT </A> Uploader : TJ Email : TJRAC@IX.NETCOM.COM Language : ENGLISH Subject : FINANCE/ECONOMICS Title : MONETARY POLICY OF THE FEDERAL RESERVE Grade : A+ System : GRADUATE SCHOOL Age : 35 Country : USA Comments : 10 PG PAPER FOR BUSINESS STUDENTS Where I got Evil House of Cheat Address : NETSEARCH Date : 5/14/96 MONETARY POLICY OF THE FEDERAL RESERVE, GUIDING THE ECONOMY I. WHAT IS THE FEDERAL RESERVE? The Federal Reserve System is the central bank of the United States. It acts as the nation╞s banker as well the primary supervisor of the nation╞s banks. Its primary function is formulating, implementing and supervisi ng national monetary policy, which is carried out by the Federal Open Market Committee (FOMC). A Brief History President Woodrow Wilson signed into law the Federal Reserve Act on December 23, 1913. At a time when the U.S. economy was expanding, the Federal Reserve system was created to halt the economic chaos. Although the Fede ral Reserve system has operated as the central bank of the U.S. since 1913, it was not the first central bank of our country. In 1791, Alexander Hamilton issued a twenty year charter for the Bank of the United States, th e first central bank of the U.S. In the late sixteenth century, the primary industry in the U.S. was agriculture. Historically, there has been great mistrust between agrarian enterprises and banking. The idea of a cent ral bank with extensive economic power was not well received by the majority of the U.S. population. In 1811, the charter for the Bank of the United States was up for renewal and was voted down by congress. In 1816 Cong ress created the Second Bank of the United States. It too was chartered for twenty years, and was more powerful than the first central bank. With its additional power it was also met with significant opposition. Its ch arter expired in 1836. After the termination of the first two central banks the country went into periods of economic chaos. From the end of the Civil War through the turn of the century the U.S. economy grew at tremendous rate. The National Banking Act of 1863 created national banks and gave them the sole privilege of note issuance. This pu t an end to state bank issued currency and created a much more stable currency. Each of the national banks held their own reserves which was not easily transferred from an institution with excess reserves to another inst itution with a greater demand. This immobility and long response times in moving reserves to where they were needed exaggerated economic downturns and brought about panic situations. Economic depressions resulted in 187 3, 1893 and 1907. The Federal Reserve Act provided for a central bank with a board made of government appointed directors, none of which could be private bankers. Currency issued by the branch banks would be the obligation of the governm ent, not the branch banks. The act authorized no less than eight regional banks but no more than twelve. In November 1914, the twelve regional banks began operations. National banks were given sixty days to decide whether they would join the Federal Reserve System, membership was voluntary. Ninety nine percent of national banks decided to join within the sixty day period as well as some state banks. Structure of the Federal Reserve System The primary function of the board of governors is the development and supervision of monetary policy through the Federal Open Market Committee (FOMC). It has supervisory powers over various depository financial institut ions and several consumer credit regulations. The board of governors operates the nation╞s payment system and has oversight responsibilities of the twelve district banks. Federal Open Market Committee (FOMC) ⌠The FOMC consists of twelve members, which include all seven members of the board of governors; the president of the Federal Reserve Bank of New York (a permanent member); and, on a rotating basis, presidents of four di strict banks, each serving a one year term.÷ Annual monetary targets are usually set at the first meeting of the year. At subsequent meetings, goals are reviewed and adjusted as necessary to keep established targets in sight. Goals of the Federal Reserve The Federal Reserve seeks a strong economy, minimal inflation and full employment. In addition to these long term goals, the Fed has two other major functions. First is its role as the ⌠lender of last resort÷ - the Fe deral Reserve is the ultimate safety net for the U.S. banking system. The second priority is to guard against severe currency depreciation. The following is a discussion of the tools that the Fed can employ in pursuit o f its long term goals. II. THE TOOLS AVAILABLE TO THE FEDERAL RESERVE Changes in Reserve Requirements All financial depository institutions operating in the United States are required, under the Depository Institutions Deregulation and Monetary Control Act of 1980, to meet reserve requirements set by the Federal Reserve. Changes in the reserve requirements will either add to or subtract from the available loanable funds. Higher reserve requirements will reduce available loanable funds while lowering reserve requirements will increase av ailable loanable funds. The desired effect being either an increase or decrease in economic activity. During periods of sluggish economic activity an increase in available loanable funds would help to stimulate the econ omy. In a recession, defined as at least two consecutive quarters of negative GNP growth, the Federal Reserve would stimulate credit expansion by increasing bank reserves, prompting interest rates to fall. An increased amount of loanable funds becomes available for business and consumer borrowing. As business activity picks up, firms increase hiring, and the unemployment rate falls. While in an overheated economy, a decrease in availa ble loanable funds would serve to slow the economy and hold down inflation. In an inflationary period when the CPI is running at a 5% rate or higher and the economy is booming, the Federal Reserve acts to cool the econom y by decreasing bank reserves. With fewer funds available, interest rates tend to rise. These higher rates discourage borrowers - both corporate and consumer - and slow economic activity. Federal Open Market Operations Desired changes in the money supply can be achieved through what is known as open market operations. By selling or buying government securities to/from the banks, the Fed can increase or decrease the amount of loanable funds. As banks are required to purchase these securities, a portion of their vault cash and their reserves on deposit with the Fed would be replaced with government securities, a less liquid asset. This serves to reduc e the amount of loanable funds available for customer borrowing and would cause the economy to slow down. Conversely, if the Fed was to purchase government securities from the banks, more loanable funds would become avai lable acting as a stimulus to economic activity. The Discount Rate Adjusting the discount rate is a another tool that the Fed has available to affect the desired impact on economic activity levels. The discount rate is the interest rate charged to member banks when they borrow directly from the Federal Reserve. As with the other monetary tools already discussed, controlling interest rates can bring about the desired effect of either increasing or decreasing the money supply. When the discount rate is raised or lowered, almost all other short term interest rates follow suit and rise or fall. Lowering interest rates would serve to stimulate the economy, while raising interest rates would reduce economic activity. A ch ange in the discount rate sends the strongest signal, of all monetary policy tools, as to the direction of the Fed╞s monetary policy. Moral Suasion Often called ⌠open - mouth operations÷, moral suasion is a monetary policy tool that is only marginally successful. By exhorting the general public to alter its spending and investment habits, the Fed along with other c entral economic figures in the government, try to achieve economic policy goals. To be successful, moral suasion must be supported by a convincing argument from credible government officials. Although moral suasion is s till employed as a monetary tool, it is not considered to be a significant tool. III. INDICATORS THAT GUIDE FOMC ACTIONS GNP Growth ⌠Gross National Product is the most important economic indicator.÷ It is the best single measure of U.S. economic output and spending. GNP is the sum total of goods and services produced by the United States. There a re four major components included in the GNP accounts: consumption, investment, government purchases and net exports. GNP = C + I + G + (X-M), where X = exports and M = imports. Inflation To measure inflation, the Bureau of Labor Statistics (BLS) measures prices of goods and services at the consumer level. The consumer price index is the most widely used measure of inflation. Since it is an index number , it compares the level of prices to some base period. Currently, the base period is the average level of prices that existed between 1982 - 1984, which is set to equal 100. Comparing the level of the index at two differ ent points in time, illustrates how much prices have risen in the interim. The index is comprised of 364 consumer items that are weighted according to a survey of consumer expenditures. Money Supply The Federal Reserve attempts to regulate the pace of money expansion in order to move towards its ultimate objective of stable, non-inflationary economic growth. There is little room for Fed error here. If money expand s too slowly, the economy will not have sufficient liquidity to grow at the desired pace. If money expands too rapidly, the result will be a pickup in the rate of inflation. Effectively, the rate of money growth is a ke y element in the Fed╞s monetary policy decisions. The Dollar By its control of short-term interest rates, the Federal Reserve has some degree of influence over the U.S. dollar. In general, higher rates tend to boost the currency, as global investors seek the highest possible yiel d. Rising U.S. rates, relative to foreign rates, tend to encourage investment in dollar denominated assets. When U.S. rates are declining (as they are currently) relative to those overseas, investment flows toward other countries and other currencies. Implementation Upon analyzing the aforementioned economic data, the Fed proceeds to set the monetary policy targets for the economy. The FOMC issues a directive to the Federal Reserve Bank of New York stating its policy. The open mar ket desk is charged with the responsibility of carrying out that policy. As a permanent member of the FOMC, the president of the Federal Reserve Bank of New York would be aware of the intent of the FOMC, and would under take open market operations to facilitate this directive. The actions of the Federal Reserve have far reaching ramifications. When we consider the future course of the economy and inflation, consideration must also be given to the likely response of the Federal Reserve Bank to these developments, which will have implications for interest rates. Fixed income markets are directly linked to interest rates. The stock market is tied to corporate profits plus the economy, inflation and interest ra tes. The dollar depends on U.S. interest rates relative to overseas rates. It is likely that the Fed will continue, as the Fed╞s favorite operating clich┌ states, to ⌠lean against the wind÷.