Example research essay topic: Monetary Policy And The Economy - 1,987 words

NOTE: Free essay sample provided on this page should be used for references or sample purposes only. The sample essay is available to anyone, so any direct quoting without mentioning the source will be considered plagiarism by schools, colleges and universities that use plagiarism detection software. To get a completely brand-new, plagiarism-free essay, please use our essay writing service.
One click instant price quote

Using the tools of monetary policy, the Federal Reserve can affect the volume of money and credit and their price interest rates. In this way, it influences employment, output, and the general level of prices. THE FEDERAL RESERVE ACT LAYS OUT the goals of monetary policy. It specifies that, in conducting monetary policy, the Federal Reserve System and the Federal Open Market Committee should seek to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

Many analysts believe that the central bank should focus primarily on achieving price stability. A stable level of prices appears to be the condition most conducive to maximum sustained output and employment and to moderate long-term interest rates; in such circumstances, the prices of goods, materials, and services are undistorted by inflation and thus can serve as clearer signals and guides for the efficient allocation of resources. Also, a background of stable prices is thought to encourage saving and, indirectly, capital formation because it prevents the erosion of asset values by unanticipated inflation. However, policymakers must consider the long- and short-term effects of achieving any one goal. For example, in the long run, price stability complements efforts to achieve maximum output and employment; but in the short run, some tension can arise between efforts to reduce inflation and efforts to maximize employment and output. At times, the economy is faced with adverse supply shocks, such as a bad agricultural harvest or a disruption in the supply of oil, which put upward pressure on prices and downward pressure on output and employment.

In these circum-stances, makers of monetary policy must decide the extent to which they should focus on defusing price pressures or on cushioning the loss of output and employment. At other times, policymakers may be concerned that the publics expectation of more inflation will get built into decisions about wages and prices, become a self-fulfilling prophecy, and result in temporary losses of output and employment. Countering this threat of inflation with a more restrictive monetary policy could risk small losses of output and employment in the near term but might make it possible to avoid larger losses later should expectations of higher inflation become embedded in the economy. Beyond influencing the level of prices and the level of output in the near term, the Federal Reserve can contribute to financial stability and better economic performance by limiting the scope of financial disruptions and preventing their spread outside the financial sector.

Modern financial systems are highly complex and interdependent and potentially vulnerable to wide-scale systemic disruptions, such as those that can occur during a plunge in stock prices. The Federal Reserve can help to establish for the U. S. banking system and, more broadly, for the financial system a framework that reduces the potential for systemic disruptions. More-over, if a threatening disturbance develops, the central bank can cushion its effects on financial markets and the economy by pro-viding liquidity through its monetary policy tools. MONETARY POLICY AND THE RESERVES MARKET The initial link between monetary policy and the economy occurs in the market for reserves.

The Federal Reserves policies influence the demand for or supply of reserves at banks and other depository institutions, and through this market, the effects of monetary policy are transmitted to the rest of the economy. Therefore, to understand how monetary policy is related to the economy, one must first understand what the reserves market is and how it works. The demand for reserves has two components: required reserves and excess reserves. All depository institutions commercial banks, saving banks, savings and loan associations, and credit unions must retain a percentage of certain types of deposits to be held as reserves.

The Federal Reserve under the Depository Institutions Deregulation and Monetary Control Act of 1980 sets the reserve requirements. At the end of 1993, 4, 148 member banks, 6, 042 nonmember banks, 495 branches and agencies of foreign banks, 61 Edge Act and agreement corporations, and 3, 238 thrift institutions were subject to reserve requirements. Since the early 1990 s, reserve requirements have been applied only to transaction deposits (basically, interest-bearing and non-interest-bearing checking accounts). Required reserves are a fraction of such deposits; the Board of Governors within limits prescribed by law sets the fraction the required reserve ratio. Thus, total required reserves expand or contract with the level of transaction deposits and with the required reserve ratio set by the Board; in practice, however, the required reserve ratio has been adjusted only infrequently. Depository institutions hold required re-serves in one of two forms: vault cash (cash on hand at the bank) or, more important for monetary policy, required reserve balances in accounts with the Reserve Bank for their Federal Reserve District.

Depositories use their accounts at Federal Reserve Banks not only to satisfy their reserve requirements but also to clear many financial transactions. Given the volume and unpredictability of trans-actions that clear through their accounts every day, depositories need to maintain a cushion of funds to protect themselves against debits that could leave their accounts overdrawn at the end of the day and subject to penalty. Depositories that find their required reserve balances insufficient to provide such protection may open supplemental accounts for required clearing balances. These additional balances earn interest in the form of credits that can be used to defray the cost of services, such as check clearing and wire transfers of funds and securities that the Federal Reserve provides.

Some depository institutions choose to hold reserves even beyond those needed to meet their reserve and clearing requirements. These additional balances, which provide extra protection against overdrafts and deficiencies in required reserves, are called excess reserves; they are the second component of the demand for re-serves (a third component if required clearing balances are included). In general, depositories hold few excess reserves because these balances do not earn interest; nonetheless, the demand for these reserves can fluctuate greatly over short periods, complicating the Federal Reserves task of implementing monetary policy. The Federal Reserve supplies reserves to the banking system in two ways: Lending through the Federal Reserve discount window Buying government securities (open market operations). Reserves obtained through the first channel are called borrowed reserves. The Federal Reserve supplies these directly to depository institutions that are eligible to borrow through the discount window.

Access to such credit by banks and thrift institutions is established by rules set by the Board of Governors, and loans are made at a rate of interest the discount rates by the Reserve Banks and approved by the Board. The supply of borrowed reserves depends on the initiative of depository institutions to borrow, though it is influenced by the level of the discount rate and by the terms and conditions for access to discount window credit. In general, banks are expected to come to the discount window to meet liquidity needs only after drawing on all other reasonably available sources of funds, which limits considerably the use of this source of funds. Moreover, many banks fear that their use of discount window credit might become known to private market participants, even though the Federal Reserve treats the identity of such borrowers in a highly confidential manner, and that such borrowing might be viewed as a sign of weakness.

As a consequence, the amount of reserves supplied through the discount window is generally a small portion of the total supply of reserves. The other source of reserve supply is non-borrowed reserves. Al-though the supply of non-borrowed reserves depends on a variety of factors, many of them outside the day-to-day control of the Federal Reserve, the System can exercise control over this supply through open market operations the purchase or sale of securities by the Domestic Trading Desk at the Federal Reserve Bank of New York. When the Federal Reserve buys securities in the open market, it creates reserves to pay for them, and the supply of non-borrowed reserves increases. Conversely, when it sells securities, it absorbs reserves in exchange for the securities, and the supply of non-borrowed reserves falls. In other words, the Federal Reserve adjusts the supply of non-borrowed reserves by purchasing or selling securities in the open market, and the purchases are effectively paid for by additions to or subtractions from a depository institutions reserve balance at the Federal Reserve.

Depository institutions actively trade reserves held at the Federal Reserve among them, usually overnight. Those with surplus balances in their accounts transfer reserves to those in need of boosting their balances. The benchmark rate of interest charged for the short-term use of these funds is called the federal funds rate. Changes in the federal funds rate reflect the basic supply and demand conditions in the market for reserves. Equilibrium exists in the reserves market when the demand for required and excess reserves equals the supply of borrowed plus non-borrowed reserves. Should the demand for reserves rise say, because of a rise in checking account deposits disequilibrium will occur, and upward pressure on the federal funds rate will emerge.

Equilibrium may be restored by open market operations to supply the added reserves, in which case the federal funds rate will be unchanged. It may also be restored as the supply of re-serves increases through greater borrowing from the discount window; in this case, interest rates would tend to rise, and over time the demand for reserves would contract as reserve market pressures are translated, through the actions of banks and their depositors, into lower deposit levels and smaller required re-serves. Conversely, should the supply of reserves expand say, because the Federal Reserve purchases securities in the open market the resulting excess supply will put downward pressure on the federal funds rate. A lower federal funds rate will set in motion equilibrating forces through the creation of more deposits and larger required reserves and lessened borrowing from the discount window. EFFECTS OF MONETARY POLICY ON THE ECONOMY As the preceding discussion illustrates, monetary policy works through the market for reserves and involves the federal funds rate. A change in the reserves market will trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit in the economy, and levels of employment, output, and prices.

For ex-ample, if the Federal Reserve reduces the supply of reserves, the resulting increase in the federal funds rate tends to spread quickly to other short-term market interest rates, such as those on Treasury bills and commercial paper. Because interest rates paid on many deposits in the money stock adjust only slowly, holding balances in money (that is, in a form counted in the money stock) becomes less attractive. As the public pursues higher yields available in the market (for example, on Treasury bills), the money stock declines. Moreover, as bank reserves and deposits shrink, the amount of money available for lending may also decline. Higher costs of borrowing and possible restraints on credit supply will damp growth of both bank credit and broader credit measures. A change in short-term interest rates will also translate into changes in long-term rates on such financial instruments as home mortgages, corporate bonds, and Treasury bonds, especially if the change in short-term rates is expected to persist.

Thus, a rise in short-term rates that is expected to continue will lead to a rise (though typically a smaller one) in long-term rates. Higher long-term interest rates will reduce the demand for items that are most sensitive to interest cost, such as residential housing, business investment, and durable consumer goods (for example, automobiles and large household appliances). Higher mortgage interest rates depress the demand for housing. Higher corporate bond rates increase the cost of borrowing for businesses and, thus, restrain the demand for additions to plants and equipment; and tighter supplies of bank credit may constrain the demand for investment goods by those firms particularly dependent on bank loans. Furthermore, higher rates on loans for motor vehicles re...

Research essay sample on Monetary Policy And The Economy