Mini Essay I
The Federal Reserve System is a body created with the aim of ensuring stability in the economy through its various operation tools. Among these tools is the monetary policy through which the Federal Reserve System controls the amount of currency in circulation. The Feds hold the monetary base by making various adjustments to their tools. The Feds can carry on its operations by changing the interest rates charged on reserves in a bid to ensure a stable economy. In this process, the Federal Reserve targets the interest rates, thus forcing an adjustment of the money in circulation to keep the interest rates at the target value. In this approach, the interest rates are not affected by the supply of money since the quantity is adjusted to keep the target interest rates.
Changes in monetary policy produce price and income effects in the economy. An expansionary plan will lead to a reduction in the rates of interest, making domestic capital and financial assets to become less attractive, lowering their real rates of returns. The foreign investors will similarly reduce their position in real estate, local stocks, bonds, and other assets. A restrictive policy, on the other hand, results in higher exchange rates, a weaker current account, and a stronger financial account.
Monetary policy similarly affects the prevailing currency exchange rates. The income effects associated with expansionary measures of the plan will lower the currency exchange rates in the domestic markets. Expansionary policy is related to an increase in the money circulation in the economy. Increased money supply consequently leads to higher spending by consumers, an increase in business investments, and improved economic growth associated with cheaper borrowing. The effect of this measure, however, is to make the capital and financial assets less appealing due to the reduced interest rates of return. The step will discourage investments by foreigners leading to a deterioration of the nation’s capital account. The overall changes associated with an accommodative policy are to lower the exchange rate of the domestic currency.
With a restrictive monetary policy, the Central Bank reduces the amount of money in circulation, limiting the ability of individuals and business entities to borrow. Limited borrowing would lead to low investment activities and reduced spending by households. The consequence of a restrictive policy is to increase the real interest rates. An increase in the interest rates will make the domestic capital and financial assets more appealing and attract foreign investors to invest in real estate, local bonds, and stocks. Similarly, private investors will be more willing to spend in their own country. An increase in domestic investment leads to a higher demand for local currency and, consequently, its exchange rate. (Gali and Monacelli 721).
The Federal Reserve Bank leadership should target interest rates to ensure the stability of the economy in today’s economic prevailing conditions. Interest rare targeting will see the adjustment of the money supply to ensure that the interest rates are kept at their predetermined values. The Fed should use open market operations to control the federal fund’s rates of providing effectiveness of interest targeting.
Mini Essay II
Monetary policy, in the short-run, affects inflation and the demand for goods and services in the economy. Consequently, the system changes the rates of employment by dictating the number of employees required for the production of products and services to meet the demand. The consequence of monetary policy influences financial conditions that face firms and households. The primary rates that have always been adjusted in the operation of the monetary policies have been the federal fund rate. The move, however, has a rolling effect touching on employment and inflation rates.
The Philips curve explains the positive relationship between inflation and output in the short run and the negative relationship between unemployment and inflation. The curve shows the relationship between output and inflation in the short term. Additionally, it explains the relationship between unemployment and output. The curve exhibits a rise in inflation resulting from an economic boom on the one hand and reduced inflation during periods of recession.
In the long run, the potential output is a determinant of the available resources and technology, while the natural rate of unemployment is determined by the labor problems in the market. Within the short run, the output of production revolves around the potential while the rates of unemployment fluctuate around the natural rate. Within a business cycle, unemployment rates and the output are inversely related to each other so that during an economic boom, the production will exceed the potential, and the rates of unemployment will be lower than the natural. During a recession, the inverse is true.
The changes in financial conditions in an economy affect the overall economic activities. When the interest rates, either long-term or short-term, reduce, borrowing becomes easier, and households are willing to purchase goods. Firms, too, are better placed to buy items necessary for the expansion of their businesses. Companies respond to these changes and shift in improved household spending by hiring more workers to increase the rates of production. An increase in the levels of employment further increases household wealth leading to more spending, which results in more expenditure and overall an effect on the general economic conditions through an increase in the levels of employment. (Levine 34).
The operations of the monetary policy have an effect on the rate of inflation in an economy. A reduction in the federal’s fund rates results in stronger demand for goods and services. An increase in demands pushes the wages and other costs of production upwards. These events reflect a higher need for the materials and workforce necessary for production. When the monetary policy put in place guidelines on the expectations regarding the overall performance of the economy regarding wages and price expectations, the actions can influence the rates of inflation in the marketplace.
In the current economic conditions, the Federal Reserve Bank membership should consider a reduction in the unemployment rates. They should put to use their monetary policy tools to achieve an acceptable unemployment level while at the same time the willingness for individual players of the economy to accept higher rates of inflation. In the short-term, there is a trade-off between unemployment and inflation. In the long run, however, reduced inflation rates will lead to severe problems with economic growth and increased levels of unemployment. The financial players are willing to accept higher levels of inflation since the policy-makers believe that higher inflation is a better option when compared to increased unemployment rates.
Mini Essay III
An occurrence of a financial crisis adversely affects the financial system of the economy, crashing the asset prices and leading to uncontrollable failures in financial institutions. Before the occurrence of the financial crisis of 2007-2009, the United States had witnessed the great depression, which had resulted in a devastating financial crisis, the Savings and Loan crisis of the 1980s, followed by a period of stable output and low inflation in the 1990s and 2000s.
The prices of housing reached their peak in 2007 and deflated in 2007, leading to defaults on mortgages. As a result, the financial institutions that had specialized in mortgage provision services went bankrupt. The deteriorating mortgage plans and organizations slowed the economy in 2007. Declining prices of houses, the lingering uncertainty, and the increasing oil prices reduced the overall wealth and consumption in the marketplace. To solve the economic problem, the Fed cut its target rate to 3%. In 2008, the losses associated with mortgage companies caused a liquidity crisis for various investment banks due to their inability to obtain funding.
During the financial problems faced by banks, the Federal Reserve stepped in and offered a loan to the primary dealers of government securities, including investment and commercial banks. The Fed further reduced its target rate to 2% in 2008, also stabilizing the financial system.
The many losses from mortgage companies pushed the government to help in bailing out these companies to avoid a default in government security bonds. The bankruptcy of investment banks as a result of the losses in mortgages further deteriorated the ailing economy. Consequently, a money market crisis occurred with the share values of companies reducing significantly. The successive failures in the market created fear among the investors who feared losing their assets, thus their decisions to withdraw their investments. Institutions only bought the treasury bills, which were considered the safest assets resulting in the fall of prices of bonds and securitization.
The declining market prices for stocks, declining house prices, reduced wealth, and the financial crisis reduced the confidence of customers and consequently spending and consumption. The disaster resulted in reduced lending and reduced securitization, which cut the available funds.
The Federal Reserve Bank, the policy-makers, as regards financial matters enacted policies aimed at providing solutions to the economic crisis. One of such solutions was the creation of Troubled Asset Relief (TARF) to buy assets from financial institutions. The Fed further invested directly in becoming a shareholder in major financial institutions. The policy-maker, through its various programs, also lent money to banks and financial institutions to increase liquidity and encourage securitization. The Fed further bought prime Mortgage-Backed Securities (MBS) in a bid to reduce interest rates on mortgages. The Fed used its monetary and fiscal policies to cut the federal funds rate to almost zero. In 2009, Congress passed the Reinvestment and the Economic Recovery Acts and allocated funds for tax cuts, aid to states, and an increase in infrastructure spending.
The Fed’s investment in MBS was a successful operation toward solving the great recession. The plan provided support for the housing market and improved other financial conditions in the economy. The Federal Reserve Bank’s action of a continued reduction in the federal fund rate was associated with a downgrade as regards the economic output and the increased adverse risks to both inflation and risking the occurrence of deflation and the economy’s production.
Levine, Linda. “Economic Growth and the Unemployment Rate.” (2012).
Gali, Jordi, and Tommaso Monacelli. “Monetary Policy and Exchange Rate Volatility in a Small Open Economy.” The Review of Economic Studies, vol.72, no.3, 2005, pp. 707-734.