THE UNITED STATES FEDERAL RESERVE SYSTEM
The Federal Reserve is the central bank of the United States of America (Federal Reserve System, 2013). It is governed by a board of directors appointed by the president, whose main responsibility is the determination of the monetary policy through the manipulation of the various monetary tools (Federal Reserve Board, 2013). The bank was originally formed in December 23rd 1913 by an act of congress and is currently headquartered in Washington D.C, with twelve other branches located in major cities across the country (Federal Reserve System, 2013).
One of the monetary tools that are used in setting the monetary policy is the discount rate. This is the rate at which the federal bank lends to other banks. Other banks may need to borrow from the Federal Reserve in order to maintain appropriate levels of the reserve requirements as set by the Federal Reserve (Kenny, 2013). The Federal Reserve can then appropriately determine whether to increase this rate or reduce in line with the most suitable monetary policy. There are three main factors that may influence the Federal Reserve to alter the discount rate, this include; the real gross domestic product, the rate of inflation and the finally the rate of unemployment. All this three factors can be influenced by the amount of money in circulation, i.e. in the case of increased inflation, the federal reserve may want to reduce the amount of money in circulation, this can be achieved through a rise in the federal discount rate in order to discourage banks from borrowing and hence lending to the public (Kennon, 2013). The level of the countries real gross domestic product also aids in the determination of the Federal Reserve’s discount rate, if it drops, the discount rate will be reduced in order to reduce the cost of capital and increase investment hence raising the real GDP. The rate of unemployment is also considered in setting the discount rate. In cases of high unemployment rates, the discount rate can be lowered in order to stimulate investment and hence reduce the level of unemployment.
The Federal Reserve discount rate does have an effect on the rate at which other banks set their interest rates. Interest rates charged by banks go a long way in determining the amount of money in circulation; if interest rates are low, access to capital is easy and more people take loans (Kennon, 2013). On the other hand should interest rates be high, less people will access funds from banks. It is also important to note that a decrease in interest rates leads to increased money supply in the country, and hence more investment which may ultimately lead to more inflation, while an increase in interest rates leads to reduced amounts of money in supply and hence low inflation. Since the federal discount rate affects the rate at which banks can borrow from the Federal Reserve, it can affect to a large extent the rate at which banks charge their interest rates to borrowers. A high discount rate will also lead to a high interest rate, while a low discount rate will lead to low interest rates.
Monetary policy can be used successfully by the Federal Reserve to reduce the levels of inflation. This can be best achieved through the use of the aforementioned tools of monetary policy. These tools include the open market operations, the discount rate and the reserve requirements of the Federal Reserve (Federal Reserve Bank of San Francisco, 2013). The open market operations involve the purchase and sale of government securities to the public. In case of high inflation, the Federal Reserve banks sell more securities in order to reduce the amount of money in circulation. When there is low inflation, the Federal Reserve banks purchases securities from the public in order to increase money supply and stimulate investment. Another tool of monetary policy that can be utilized by the Federal Reserve System is the required reserves commercial banks are supposed to keep with the Federal Reserve banks. In case of high inflation, the federal bank raises the reserve requirements to reduce money supply (Baker, 2011), when the rates of inflation fall, the Federal Reserve lowers the reserve requirements to increase the amount of money in circulation.
A monetary stimulus program is either an expansionary fiscal or monetary policy that aims to increase the amount of money in circulation (Carpenter & Demiralp, 2010). In response to such expansionary policy, commercial banks can lend more money than they were able to previously. The amount of money that commercial banks can be able to lend as a result of increased government spending is usually a multiple of the same. Hence a monetary stimulus package may increase the amount of money in circulation and hence the money supply. This is made possible by the multiplier effect, as the amount of increase in the government spending is multiplied.
Currently in the United States, indicators show that there is too little money in the economy. The demand for housing has fallen by 80% in 2012 (Roubini, 2012), and the fiscal deficit has not yet been eliminated. The current economic situation is characterized by slow growth in demand for products in general, a further indicator that there is too little money in the economy. Monetary policy can be used to remedy the situation. Expansionary monetary policy that aims to increase the amount of money in circulation can be undertaken. This includes such measures as decreasing the reserve requirements, to enable banks to create more money that can be lent out. The federal banks can also reduce the Federal Reserve discount rates, to enable banks to borrow at much more cheaper rates and consequently lend at the same rate to their clients. The Federal Reserve banks can also use the open market operation to increase the amount of money in supply in the country; this will mainly involve the purchase of government securities that are held by the public in order to facilitate the transfer of funds from the government to the public.
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Carpenter S. & Demiralp S. (2010). Money, Reserves, and the Transmission of Monetary Policy:
Does the Money Multiplier Exist? Retrieved from: http://www.federalreserve.gov/pubs/feds/2010/201041/201041pap.pdf
Federal Reserve Bank of San Francisco. (2013). Monetary Policy. Retrieved from: http://www.frbsf.org/publications/federalreserve/monetary/tools.html
Kennon J. (2013). The Federal Reserve and Interest Rates. Retrieved from: http://beginnersinvest.about.com/od/banking/a/aa062405.htm
Kenny T. (2013). What is the Discount Rate? Retrieved from: http://bonds.about.com/od/Issues-in-the-News/a/What-Is-The-Discount-Rate.htm
Roubini N. (2012). Economic upturn in America? Don't be too hopeful. Retrieved from: http://www.guardian.co.uk/business/economics-blog/2012/jan/13/economic-upturn-america-hopeful
The Federal Reserve System Online. (2013). Retrieved from: http://www.federalreserveonline.org/
The Federal Reserve Board. (2013). The Structure of the Federal Reserve System. Retrieved from: http://www.federalreserve.gov/pubs/frseries/frseri.htm