351 FIN Project 1
Running head: FIN 351 Project
FIN 351 Project
Aliceya Perkins
FIN 351
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The Federal Reserve monetary strategy of the last five years has resulted in the lowering
of the U.S. Dollar exchange rate. The Federal Reserve followed this strategy because it has an
express mandate in the control of the supply of money in the marketplace. The U.S. Congress
established two key objectives for monetary policy--maximum employment and stable prices--in
the Federal Reserve Act. These objectives are sometimes referred to as the Federal Reserve's
dual mandate. (Federal Reserve Board 1988).
The dual mandate is the long-run goal for monetary policy, and the Congress also established
the Federal Reserve as an independent agency to help ensure that this monetary policy goal can
be achieved. The independence of the Federal Reserve in conducting monetary policy is critical
to guaranteeing that monetary policy decisions are free from political influence and focused
exclusively on achieving the Federal Reserve's dual mandate. For example, a problem
experienced in many countries without an independent central bank is that elected officials have
put pressure on monetary policymakers to follow policies that boost the economy in the short run
even if doing so would result in high levels of inflation later on. The Federal Reserve's dual
mandate and the provisions for the independence of the Federal Reserve are two key factors that
help guard against such outcomes in the United States.
The strategy that the Federal Reserve has employed, in terms of monetary policy over the
past five years, has largely been unsuccessful. One key reason for this failure is that the Federal
Reserve is less independent of the U.S. government than it appears to be; thereby preventing it
from acting solely in the best interest of the country. More specifically, what the U.S. Congress
creates, the U.S. Congress can modify or destroy. Congress has from time to time established guidelines
or objectives for the Fed (e.g. Humphrey-Hawkins, 1978). The Fed remains independent because most
politicians want it that way. They mostly agree that monetary policy is not a partisan issue. An
independent Fed can also absorb blame if the economy falters, and take necessary but unpopular steps to
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combat various economic ills. If Congress should change its mind, the Feds independence could vanish
at the stroke of a pen.
In addition to the false independence of the Federal Reserve, its powers as they were originally
intended has been diluted due to expansion of the money supply since its inception in 1913. The Fed has
centralized as the U.S. has evolved from a confederation of regional economies to a truly national
economy. The twelve Federal Reserve Banks, once largely autonomous in their respective regional
districts, remain operationally important but have lost their authority to set monetary policy. They are a
minority, currently comprising five votes out of twelve on the Federal Open Market Committee, which
sets U.S. monetary policy under ultimate control of the Board of Governors.
Principally, money operates as a medium of exchange. Money was established and developed
in order to make possible the purchasing and selling of both products and services. In todays
society, money has additionally become a standard measure pertaining to the worth of wealth for
both private individuals and businesses (Data Limitations and the Fragmented U.S. Financial
Regulatory Structure Challenge Federal Oversight and Enforcement Efforts, 2009). In theory, the
entire money supply of the United States in under the direct control of the Federal Reserve System. If the
Federal Reserve were a business, the supply of U.S. dollars and currency would be equivalent to cash as a
current asset on its balance sheet. The Fed controls the bank reserve component of the monetary base and
changes the bank reserve account (liability) chiefly through open market operationsbuying or selling
U.S. government securities, such as Treasury bills and Treasury notes (asset).
When a Fed asset
increases, the monetary base increases.
By exclusively controlling the monetary base, the Fed substantially controls the money supply.
To meet reserve requirements, depository institutions must deal in monetary base assets by either
depositing adequate reserves with the Fed or holding adequate quantities of Federal Reserve Notes in
their vaults. Either way, they earn no interest. The more they hold above requirements, the more they
want to avoid lost interest income. Excess reserves appear as the Fed buys securities on the open market,
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lends at the Discount Window, or cuts reserve requirements. As depository institutions lend or invest
excess reserves, new loans or investments increase M1 and finance purchases in the real sector. By
expanding or contracting the monetary base, the Fed increases or decreases excess reserves, thus raising
or lowering incentives to lend or invest, thus encouraging or discouraging expansion in real sector.
As a general rule, if the interest rate is high, the amount of money that is accessible is
typically low. When it comes to the higher reserve requirement, there is a requisite for financial
institutions to deposit with the Federal Reserve, which in turn, additionally affects the amount of
money which is accessible for lending purposes, as this typically lowers that amount (Mark,
2009). When it comes to an open market operation, the Federal Reserve has the ability to both
purchase and sell Unites States Treasury within the market in order to calculatedly affect the
amount of money which is accessible in the system.
The purpose and intentions of the monetary policy within the United States are comprised
within the Federal Reserve Act which was established by the Federal Reserve. Basically, it aims
to effectively support and sponsor the objectives of maintaining elevated employment rates,
unwavering prices, in addition to restrained long-term interest rates. As a result of the current
economic crisis, the Federal Reserve has opted to implement an expansionary monetary policy
(Tulip, 2009). Basically, such an expansionary monetary policy entails that the Federal Funds
interest rate will be reduced. As depicted Figure in 1.1, the Federal Funds interest rate is
presently at one of its lowest levels.
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Figure 1.1
For the past five years, the Fed has kept the overnight lending rate to banks near 0.00%. Taking
this action increases the monetary base excess reserves will increase, pressuring the benchmark Fed
Funds Rate downward.
As depository institutions lend or invest the excess reserves, the deposit
component of M1 will expand. Traditionally, falling interest rates and increased credit availability made
saving less attractive than spending, increasing the value of existing fixed-rate financial assets in which
prior savings may have been invested, and lowering the financing costs of big ticket items, thus
encouraging additional consumption. The formula has not worked out as planned lately. Businesses are
hording capital and not hiring. Consumers are hording cash and cutting consumption. Essentially, the
wheels of the economy have fallen off.
In order to elucidate on the effects of monetary policies on the economys production and
employment, it would be fitting to use the example of the current credit crisis in which the
United States is suffering. In order to combat the current state of the economy and rid the country
of the recession, the Federal Reserve has implemented various monetary policies. These
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monetary policies include the Federal Reserve reducing interest rates in an attempt to get the
economy back on its feet. The Federal Reserves action of reducing the short-term interest rates
seeks to increase the markets overall supply of money and at the same time, stimulate and
encourage financial institutions to start lending to businesses again (Tulip, 2009).
While the Federal Reserve lacks true independence from the U.S. government, has had its
original powers severely eroded due to the expansion of the money supply, and has effectively created a
vacuum of debt by keeping interest rates too low for too long, they also face external threats beyond their
control due to the speculation of investors. The Federal Reserve is very sensitive to uncertainty in the
market. They go through great lengths to telegraph their announcements so as to minimize adverse effects
from changes in monetary policy on the economy. This leads to a situation where investors act
independent of Federal Reserve policy using speculative financial instruments like credit default swaps to
generate more cash.
Traditional thrifts, taking relatively short-term fixed-rate deposits to fund relatively long-term
fixed-rate mortgages, ran a constant and unhedged negative maturity GAP. Thus rising interest rates
would erode both their net worth and their net interest margin. A thrift expecting an increase in interest
rates today might promote variable-rate loans more aggressively, or shift more loanable funds to less
interest-sensitive securities, or promote longer-term deposits, or seek longer-term nondeposit sources of
funds. In response to this uncertainty, investors who speculate have might gone off balance sheet to sell
financial futures, buy puts on futures, or swap fixed interest streams for variable interest streams. Heres
the big problem. The Federal Reserve has keep interest rates low to push more money into the economy.
At the same time, speculative investors are essentially betting against the success Federal Reserve policy
and generating paper cash that essentially has no worth. The result has been the near total stagnation of
the U.S. economy.
The Federal Reserve maintains that its pursuit of expansionary monetary policy in the
midst of the current recessions will surely permit the economys recovery to occur as quickly as
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possible. As such, the levels of housing, consumer spending, and investments by businesses
have recently all been rising; however, they are still unstable. The unemployment rate,
nonetheless, is still not on the rise. It is expected that these rates will soon rise, and that GDP will
increase as well. The recent progression of the economy will most-likely warrant the
implementation of a monetary policy that will be the very opposite, as soon as the levels and
rates become stable again; it will tighten the supply of money by increasing the Federal Funds
interest rates (Mark, 2009). By tightly controlling the Federal Funds interest rate, the Federal
Reserve is attempting to reduce the speed in which the economy is growing in order to create and
maintain a more stable economy.
In retrospect, this assignment allowed me to clarify previous misconceptions concerning
the amount of influence that the Federal Reserve has over the aggregate performance of the U.S.
economy. Frankly, there are a vast number of moving parts involved in the process of keeping
the momentum of the economy moving in a positive direction. Since the actions of the Federal
Reserve are typically reactionary, there seems to be a significant lag time between the issuance of
a change in their approach towards monetary policy and any effects that might have on the U.S.
economy at large. I suppose that when I turn on the television and begin viewing the repeated
talking heads over unemployment levels and consumer confidence, that I have a slightly better
understanding on what is actually happening.
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References
Data Limitations and the Fragmented U.S. Financial Regulatory Structure Challenge Federal
Oversight and Enforcement Efforts. (2009, August 12). GAO Reports, Retrieved 4 August
2011, from Business Source Premier database.
Mark, N. (2009, September). Changing Monetary Policy Rules, Learning, and Real Exchange
Rate Dynamics. Journal of Money, Credit & Banking (Blackwell), 41(6), 1047-1070.
Retrieved 4 August 2011.
Tulip, P. (2009, September). Has the Economy Become More Predictable? Changes in
Greenbook Forecast Accuracy. Journal of Money, Credit & Banking (Blackwell), 41(6),
1217-1231. Retrieved 4 August 2011.
United States. Federal Reserve Board. (1998, July 22). Conduct of monetary policy; Report of the
Federal Reserve Board pursuant to the Full Employment and Balanced Growth Act of 1978; July
21, 1998 report. Retrieved 4 August 2011 from the Federal Reserve Web site:
http://www.federalreserve.gov/boarddocs/hh/1998/july/fullreport.htm