Federal Reserve overview and study.

Name

10/26/2011

Bus 254 Macroeconomics

1a.       Question 1a: (15 points) Federal Reserve overview and study.

The Federal Reserve Bank has two basic goals. The first is to promote sustainable output and employment. The second is to ensure stable prices which means low, stable inflation. The Federal Reserve does not directly control inflation, output, or employment and it does not set long-term interest rates. The Reserve indirectly influences these vital economic variables, mostly by using the federal funds rate. The federal funds rate is the interest rate institutions in the Federal Reserve System charge each other for overnight loans of reserves, which are often needed to meet minimum requirements. Depository institutions in the reserve system are required to hold a minimum reserve balance at Federal Reserve Banks.

 When the Federal Reserve wants to slow inflation it uses monetary policy tools to raise the federal funds rate. When the federal funds rate rises monetary policy is called tight, or contractionary. When the Federal wants to counter recessionary pressures the Fed uses it’s polices to lower federal fund rates. When rates fall monetary policy is said to be easy, expansionary, or accommodative.

The Federal Reserve has historically used three tools to conduct monetary policy: open market operations, the discount rate; and reserve requirements. Recently it has come up with new ways to affect monetary policy such as paying interest on reserve balances. The Reserve has also used temporary nontraditional tools in the last few years to combat a weak economy.

Open market operations are the Reserves most used policy tools. What the open market operations are, are basically buying and selling U.S. government securities on the open market with the goal of aligning the federal funds rate with a publically announced target set by the Federal Open Market Committee. The open market operations are conducted by the Federal Reserve Bank of New York at its trading desk. If the Federal Open Market Committee lowers the target federal funds rate, then the trading desk will buy securities on the open market. The Federal Reserve pays for the securities by crediting the reserve accounts of the banks that sell the securities. When the Reserve buys securities in the open markets it is creating money. When the Federal Reserve creates money and credits it into reserve accounts it puts downward pressure on the federal funds rate. With lower federal funds rates, the interest rates that are directly and indirectly linked also tend to fall. With lower interest rates businesses and consumers are encouraged to spend stimulating economic growth.

When the Federal Open Market Committee raises its federal funds rate then the trading desk sells government securities, collecting payments from banks by withdrawing money from there reserve accounts. Less money in reserve accounts means less money in the banking system putting pressure on the federal funds rate. By selling government securities market interest rise which slows consumer and business spending which slows the economy but also reduces the rate of inflation.

The Federal Reserve may also change the reserve requirements, which is the amount a financial institutions are required to hold in reserve. By changes this it can add or remove money from the Banking system, it is rarely used. The discount rate is also an option the Federal Reserve has its disposal to influence the amount of money in the banking system. Unlike the open market operations the discount rate is set by the Federal Reserve. The discount rate is used as a lender of last resort which occurs when the open market lending freezes up. The Reserve in 2008 was granted authority to pay interest on reserve balances. This has the effect of creating a floor beneath the federal funds rate because banks are not willing to loan to each other at rates far below what they can earn by leaving their reserves on deposit with the Federal Reserve. The Federal Reserve also devised nontraditional tools to lower borrowing costs for consumers and businesses. One tool used was large-scale purchases of long-term securities, including Treasury securities, federal agency debt and federal agency mortgage-backed securities. These purchases lowered long-term interest rates including mortgage rates.