The Three Policy Tools of Federal Reserve

 

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The Federal Reserve System is the central banking institution in the United States - The Three Policy Tools of Federal Reserve introduction. Throughout its history, the Fed always worked to maintain reasonable balance in economic and financial systems, and to protect customers and businesses from the negative impacts of crises. Since the very moment it was founded, the roles and responsibilities of the Fed have been gradually expanded to cover a whole range of issues and to provide essential financial and economic support, as well as adequate and objective information to financial market players and consumers. Now, with the advent of the new financial crisis, the Fed fights to increase the effectiveness of its policy instruments, of which interest rates is still the most important.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The Three Policy Tools of Federal Reserve

Introduction

The Federal Reserve System is the central banking institution in the United States. Throughout its history, the Fed always worked to maintain reasonable balance in economic and financial systems, and to protect customers and businesses from the negative impacts of crises. Since the very moment it was founded, the roles and responsibilities of the Fed have been gradually expanded to cover a whole range of issues and to provide essential financial and economic support, as well as adequate and objective information to financial market players and consumers. Now, with the advent of the new financial crisis, the Fed fights to increase the effectiveness of its policy instruments, of which discount rate is still the most important.

The Fed is the central bank of the United States. Founded in 1913 to protect consumers and businesses from panics, the Fed had been able to expand the range of its responsibilities and functions to become the central element of monetary policy development and implementation in the U.S. (The Federal Reserve Board, 2005). The Fed is designed in a way that promotes flexible approaches to monetary policy solutions, as well as objectivity and professionalism in all strategic decisions. The major Fed’s component is the Federal Open Market Committee, made up of the Board of Governors, the President of the Federal Reserve Bank of New York, and the presidents of other four Federal Reserve Banks. The FOMC works to control and monitor the impact, which its monetary decisions produce on the overall state of the American economy (The Federal Reserve Board, 2005).

Where the Fed seeks to implement effective monetary policies, its strategic goals always include price stability, maximum employment, and maintaining moderate interest rates in the long-term period. Federal reserves, discount rates, and open market operations are the three major policy tools the Fed uses to manage monetary supply. It should be noted, that open market operations is the tool which the Fed actively uses to maintain economic stability in the U.S. Open market operations imply that “the Fed buys and sells government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York” (The Federal Reserve Board, 2005). However, when open market operations do not produce desired economic effects, bank reserves come into action. The word combination “bank reserves” is related to the amount of funds banks and financial institutions are required to reserve in order to cover daily and emergency operations. By managing the required amount of bank reserves the Fed controls the amount of cash banks can use for loan and investment purposes. Finally, the Fed actively works to regulate the level of the discount rate, or the interest rate which banks have to pay to the Federal Reserve for short-term loans. For the majority of American customers and businesses, discount (or interest) rate is the central measurement and the basic criterion of the monetary policy in the U.S. Whenever the Fed changes the discount rates, these changes work to predict the direction of the Fed’s policymaking in short and long run.

Interest rates are directly linked to inflation and determine the amount of money customers and businesses can use to satisfy their needs. By raising interest rates, the Fed strives to decrease money supply in economy. As a result, banks face the need to reduce their lending operations and to raise the interest rates they charge to customers. Customers and businesses are no longer able to borrow. The amount of spending in economy decreases, too. People spend less money for goods and services. With the decreasing demand, manufacturers have to lower their prices in order to maintain reasonable balance between supply and demand, and as soon as prices go down, inflation also becomes less probable. Nevertheless, raising interest rates may also lead to negative consequences. The amount of those who can afford repaying their loans to banks decreases; people spend less and do not have an opportunity to save money. Ultimately, banks can face the crisis of liquidity, being unable to cover their basic financial needs.

Conclusion

The Fed is the central bank of the United States. The Fed’s major task is maintaining long-term economic stability in the U.S. Open market operations, bank reserves, and discount rates are the three major policy tools the Fed uses to manage money supply, and although raising interest rates is expected to reduce inflationary trends in economy, the Fed should be particularly attentive to the impacts, which higher interest rates are likely to produce on lending activity and liquidity of banks in the U.S.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

References

The Federal Reserve Board. (2005). The Federal Reserve System: purposes and functions.

Federal Reserve. Retrieved May 1, 2009 from http://www.federalreserve.gov/pf/pf.htm

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