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Federal Reserve and Monetary Policy

Updated on September 4, 2010

Problems faced by the FED

The FED is currently facing several problems, one of which is slow economic growth. Even though interest rates are reaching record lows, the bank’s requirements for loans are so strict that a lot of potential borrowers don’t qualify for the loans. One reason banks are not giving out as many loans is because of moral hazard. The unemployment and foreclosure rates are high so banks are at risk for defaulted loans. The FED could help stimulate the economy by lowering the reserve requirements and the discount rate. This would give the banks more flexibility in lending and people wouldn’t be so worried about appending money.

Another problem the FED faces right now is financial market instability. The Dow Jones industrial average, the S&P 500 (SPX) and the Nasdaq (COMP) have all seen volatile conditions recently. The FED could help the stock market to go up by lowering the interest rates. When the interest rates go down, the stock market goes up.

A third problem faced by the Fed is that a policy that is meant to achieve one monetary policy goal may have a negative effect on another policy goal. For example, if the FED chooses to lower the interest rates to make the stock market go up, then they would eventually have to raise them again. The fluctuations in interest rates could then hinder economic growth.

How the FED affects the banking sytem

The Federal Reserve affects the banking system through open market operations (OMO) in several ways. One way the FED affects the banking system the buying of securities. If a lot of checks are clearing or a lot of deposits withdrawals are taking place in a day, the banks reserves will fall. The central bank can then step in and buy securities to raise the reserves back up. These fluctuations can often be predicted and the security purchases can be done before the reserves fall to low.

Another way the FED affects the banking system with OMO is through selling securities. If the amount of reserves held by bank is expected to rise, the Fed can sell securities to prevent major fluctuations in the reserves. Open market operations are very flexible so they can be used on a very small or a very large scale.

A third way the FED uses OMO to affect banking operations is through temporary transactions like repurchase agreements and matched sale-purchase transactions. The are short-term open market operations in which securities are bought or sold with the agreement to buy or sell them back in a very short term. These allow the FED to make temporary adjustments to banking operations that will be reversed in several days. They could be used in the case of a storm coming through that will delay check clearing. Temporary transactions would keep the reserves balanced until the storms pass and checks start clearing.

Reserve Requirements

Reserve requirements are the amount of cash that the bank is required to keep on hand to fulfill deposit withdrawals. When the FED decreases the reserve requirements it causes the federal funds rate to fall. When the bank is required to keep less money in reserves, they are able to lend that money out, in effect promoting economic growth.

Discount Loans

The FED can also affect bank operations by lowering the rate in discount loans. The interest rate on these loans is typically set higher than the federal funds rate target, and in most conditions the amount of discount lending under the primary credit facility is very small. As a lender of the last resort, the FED can lower the discount rate and offer discount loans to bank to prevent failure and bank panic.

Targets for monetary aggregates and interest rates

The FED can set intermediate targets for either monetary aggregates or interest rates, but can not set targets for both of them at the same time. This is because the demand for reserves fluctuates with unexpected deposit transactions and banks decisions on reserve holding. Because intermediate targets on monetary aggregates and interests rates will have adverse effects on each other, the FED must choose just one of the targets to set by examining observability, measurability, controllability and predictable effect on goals.

The economy is currently in an unstable condition. Stocks prices are falling and prices on Treasury bonds are rising. The FED has vigorously been trying to solve the economic crises but there comes the problem of solving one monetary policy goal has a negative effect on another goal. For example, economic growth will most likely be accompanied by inflation.


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      vinsanity 6 years ago

      This is a very well written hub here, good job. I think that our national debt might be a problem that we can never get out of, no matter how much the Feds try to fix it.