Role of Federal Reserve
In the past few years, the Federal Reserve has come under increased scrutiny due to the financial crisis of 2007 – 2009. It has been criticized for lowering the interest rates, which resulted in cheaper mortgages, and thereby precipitating into a full blown financial crisis. Further, it has also been criticized for transforming itself into an investment vehicle, due to its role in quantitative easing, even though it helped in financial recovery.
Historically, it has been Federal Reserve’s dual mandate to maintain the stability of prices and employment. That it does by varying its federal funds target, by alternating purchase and sales of US treasuries and federal agency securities. It is measured for its aptness by the Taylor’s rule, which was developed by the Stanford economist, John Taylor. The rule suggests that interest rates should be increased when inflation or employment rates are high, and vice versa.
Such exercise of control over financial matters is made possible due to the control by the Chairman. Among other things, he acts as a spokesperson for the bank; negotiates with the Congress and the President; and controls the agenda of the board and FOMC meetings.
Following the economic crisis of 2008, the Federal Reserve has also been entrusted with the role of overseeing systemic risk. This has prompted some to raise doubts about how it going to fulfill both the mandates. They believe managing both these roles may result in undermining of the price stability.
Among other methods the Federal Reserve uses to stimulate the economy is by lowering the interest rates, increase investment, and boost job growth. This it does by issuing long-term debt in form Treasury Bonds. This regulatory concept is called Quantitative Easing. This make available more resources to the country’s financial system, banks free to lend, and easy for public to borrow.
The Federal Open Market Committee (FOMC), which is an arm of the Federal Reserve, has a “dual objective of maximum sustainable employment in the context of price stability”. To promote a strong recovery it made certain important changes. First, it purchased additional mortgage based securities. Next, for the first time, it will continue to buy assets until there is significant improvement in outlook of the labor market. Lastly, it agreed to a highly flexible approach to a monetary policy to a point beyond the point of recovery.
This additional stimulus provided by it has resulted in improvement in labor market conditions. It needs to be emphasized that its policy is based on outlook of the labor market, and not the level of employment or unemployment at any point of time.
The Federal Reserve also uses communications as a policy tool. This tool is also called “forward guidance”, and it informs the public regarding the path FOMC is expected to take. Such an approach makes policy more effective by reducing the risk of misinterpretation of FOMC’s intention by market forces. Also, their policy makers take up the challenge to create a plan such that it puts the U.S federal budget on a sustainable long-term path without affecting the recovery.
Analysis of Economic Indicators to better Stabilize Economy
The Federal Reserve uses the following key economic indicators to give an overview of the economy. A good analogy would be doctor checking the vital signs of the patient. The major indicators would be gross domestic product (GDP), consumer price index (CPI), and the unemployment rate. The FOMC, the policy making body of the Federal Reserve, examines many such indicators before finalizing the monetary policy.
Here would be some examples of data and indicators from the New York Fed. They conduct a Business Leader’s survey in the state of New York, northern New Jersey, and southwestern Connecticut. They also conduct a monthly survey of manufacturers in the New York state, called the Empire State Manufacturing Survey. It also conducts a single summary statistics of the economic activity in New York State, called the Indexes of Coincident Economic Indicators.
It publishes a Quarterly Report on Household Debt and Credit, which is an analysis of the trend in consumers’ borrowing and indebtedness. It is based on the FRBNY Consumer Credit Panel. Further, it also publishes a Supplemental Survey Report, which is summary of response to topical questions in the Business Leader’s Survey and the Empire State Manufacturing Survey. It also publishes the FRBNY Survey of Consumer Expectations, which is a monthly survey about “inflation, future earnings, household income, house prices, access to credit, layoff risk, and U.S. economic conditions overall”. In addition, it also publishes the Quarterly Trends for Consolidated U.S. Banking Organizations. This tracks the consolidated financial condition of the American “commercial banking industry, including aggregate trends in profitability, assets, capital, and other key variables”.
Taking examples from the Federal Reserve Bank of Richmond, we will now elaborate on economic indicators in a greater detail. These indicators have been broadly classified into: (a) GDP, (b) Households, (c) Investment, (d) Trade, (e) Manufacturing, (f) Labor Market, (g) Inflation, (h) Monetary Policy, and (i) Financial Markets.
Elaborating further on the GDP, we find that it measure a few specific indicators such as, personal consumption expenditures, nonresidential fixed investment, residential fixed investment, exports of goods and services, import of goods and services, government consumption expenditures & gross investments. Changes in these indicators are measured on a quarterly basis.
The measurement of household indicators can be further divided into: (a) retail sales, (b) personal income and expenditures, (c) personal savings, (d) sales in automobiles and light trucks, (e) single-family home sales, (f) private single-family housing starts and permits, and (g) private multi-family housing starts and permits.
The indicators related to trade and manufacturing include: (a) balance of international trade, (b) industrial production index, (c) capacity utilization rate for the manufacturing sector, (d) manufacturers’ new orders, (e) core capital goods, and (f) inventory/sales ratios.
Those related to labor market include: (a) nonfarm payroll enrollment, (b) civilian unemployment rate, (c) civilian labor force, (d) aggregate weekly hour index, (e) employment cost index, (f) labor productivity from nonfarm business, and (g) unit labor cost from nonfarm business.
Other important indices include: (a) expenditure price indexes, (b) consumer price index, (c) producer price index, (d) monetary policy instruments, (e) money market rates, (f) capital market rates, (g) treasury yield curve, (h) risk premium, and (i) exchange rate.
Monetary Policies the Federal Reserve
Monetary policies have both short and long term effect on the overall economy. In the short run, a monetary policy that reduces the interest rates increases the “interest-sensitive spending”. This interest sensitive spending includes capital investment by companies, investment in residential complexes, and spending on consumer durables. This policy also encourages the depreciation of exchange rate, which causes rise in exports and fall in imports. Conversely, to reduce the spending in economy, the Federal Reserve increases the interest rates. A historical analysis U.S. economy will show that money and credit induced expansion in demand has had a positive impact on its GDP and total employment. The degree to which the interest-sensitive spending causes increased overall spending in the economy, in the short run, depends on how close the economy is to full employment. The assumption here is that it will have a full impact only if people are employed, and are willing to spend in response to these measures. Put in other words, if the economy is near full employment, the increase in spending is dissipated through increase in inflation rather quickly. Conversely, when the economy is way below the full employment level, the inflationary pressures are generally muted.
This same principle over a longer term suggests that a rapid growth of money and credit is largely dissipated by rapid rise in inflation. It does not have any long-term effect on the real GDP or employment.
According to the economist, there are two broad explanations for these behaviors. Firstly, they contend that in the short term, most economies have elaborate system of contacts that prevent, in the short-term, any adjustment to take place in wage rate and prices in response to rapid rise in money and credit. Secondly, they believe that the expectations are slow to adjust to long-term consequences of a major shift in the monetary policy. This slow process of adjustment makes the wages and prices rigid. It is because of this rigidity, any change in growth of money and credit, that has a large initial impact on the output and employment with a lag of six to eight quarters before the whole economy exhibits full response to the monetary policy measures.
Evaluating the impact over the long-term, we observe that as the contacts are negotiated and expectations adjust, the rise of wages and prices in response to the change in demand and most of the change in output and employment is undone. Therefore, we conclude that the monetary policies make a difference in the short-term. But in long-term, they will have minimal impact on GDP growth and actual employment.
It needs to be observed that in those societies which have high rate of inflation, adjustments to price are very rapid. Further, in the final stages of very rapid inflations, also called hyperinflation, the more rapid growth of money and credit is unable to alter growth in GDP and employment.
Monetary Policy vs Fiscal Policy
Either of these two measures can be used to alter the overall spending of the economy. However, we need to examine several important differences between the two.
First, in actual the economic conditions change very rapidly. In such situations, the monetary policy can be very swift to bring about changes. This can be highlighted by the fact that Federal Reserve meets every six weeks to consider making changes to the interest rates. If required they even call for an unscheduled meeting in between. In contrast, any large change to the fiscal policy only happens once a year. Also the process of making changes to the fiscal policy is long and complicated. Once a decision to make changes is made, it has to follow a long legislative process, which can take anywhere up to six months before it can be made a law. In contrast, the changes to the monetary policy can be made almost instantaneously. In addition to the implementation lag, these policies are also face lag from the “pipeline effect”.
Second, because of the political ramifications, the fiscal policy changes are mostly made in one direction. In any business cycle, an aggregate spending in the economy can either be too high or too low. This implies that the stabilization policy needs to be tightened as often as it is loosened. At the same time it has been observed that increasing budget deficit is more popular move than spending cuts or increase in taxes – that reduce the deficit. In contrast, the Federal Reserve is more insulated from political pressures. In contrast to fiscal approach, which has results in near perpetual deficit situation, the monetary approach of Federal Reserve has seen even swings in both the directions.
Third, the long term consequences of the fiscal and monetary policies are different. Any expansionary fiscal policy increases debt burden that will have to be shouldered by future generations. Some of this debt will be owed to domestic population or corporations, and some of it will be to foreign concerns. In summary, the expansionist fiscal policy reduces the future national income to what it would otherwise have been. In contrast, the monetary policy does not have this kind of impact on the next generation. Even though, different levels of interest rates will impact the borrowers and lenders. Also, budget constraints put limitations on the scope of the fiscal policy.
Fourth, economy’s openness to highly mobile capital flow changes the relative effectiveness of the monetary and fiscal policy. Expansionary fiscal policy will lead to higher interest rates, which will attract foreign capital looking for higher rate of return. On the other hand, expansionist monetary policy would have the opposite effect. That is lowered interest rate would cause the foreign capital to flow abroad in search of higher interest rate elsewhere.
Fifth, the fiscal policy can be used to selectively target a segment of the economy. This is something which the monetary policy cannot. This can be considered both an advantage and a disadvantage. Policy makers can contemplate fiscal stimulus to target a particular sector, which is most in need. And the response is most likely positive. Conversely, the stimulus can be allocated on the basis of political or other non-economic factors: that reduce the effectiveness of the overall stimulus.
Effect of Aggregate Demand/Supply Model
The Federal Reserve can control the money supply in the market place by either lowering or increasing the discount rate, and reserve ratio. Typically, an increase in money supply leads to lower interest rates. In that situation the consumers will want to invest more of their money than to withhold it. This is because with lower interest rates the opportunity cost for holding the money is less. However, with the interest rates falling, the demand for investment increases. In such a situation, business may want to take advantage of the reduction in opportunity costs by investing in new machine and plants. And households may decide to invest in real estate.
In summary, if supply of money increases, the interest rates decrease. This drop in interest rates encourages people to invest in household and in business. So, as the investment increases, the aggregate demand also increases at a given price level. Therefore, the output or GDP also increases.
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