Financial Policies of the Federal Reserve
The Federal Reserve is a quasi-banking institution that basically oversees the welfare of the economy and set monetary policies to encourage economic growth (Epstein 2003, 273). The Federal Reserve is also able to control the growth rate of the local economy by controlling the money supply. As discussed in the previous section, the interest of the Federal Reserve with regard to interest rates and inflation is simply due to the close relationship between interest rates and inflation to the money supply which greatly affects the foreign exchange rate of the dollar and economic growth (Epstein 2003, 273).
By controlling short-term interest rates, the Federal Reserve is able to influence interest rates in general because of its size. The Federal Reserve can also do this by controlling the open market operations by increasing the federal funds rate, which is the rate that banks charge on loans from other financial institutions for funds that originate from the federal funds (Baker 2005, 205). Thus by expanding or contracting the money supply by manipulating the exchange rates, the Federal Reserve is able to effectively combat any inflation that may occur and also regulate the value of the local currency in the foreign exchange market.
This also results in more favorable balances in trade. The concern of the Federal Reserve with regard to inflation can be stated in this manner. Inflation can be one of two things for the Federal Reserve, it can be a cause or it can be an effect, indicating certain changes within the economy (Baker 2005, 205). As a cause, inflation concerns the Federal Reserve because it can be an indicator that there is a growth stimulus in the economy and it warns the Federal Reserve that it must influence the money supply by increasing interest rates (Baker 2005, 205).
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As an effect, it tells the Federal Reserve that the economy is in recession and must react accordingly. These two factors therefore greatly affect the monetary policies that the Federal Reserve implements in controlling the money supply. Other steps that the Federal Reserve and the National Treasury have taken include the strengthening of capital position and funding ability of American Financial Institutions. These are to be achieved through multilateral agreements such as the reciprocal currency arrangement (Swap Lines) with International Central Banks.
Finally, the heralded US $700 billion bailout plan that was recently enacted into law has also been designed to infuse much needed capital into the market and to protect the exposure of several multinational and local financial institutions. The direct relationship that interest rates, inflation and even higher wages have on the amount of money supply is a matter of importance for the Federal Reserve because as shown in this study, and change in these factors could increase or decrease the money supply and adversely affect the economy of the United States.
The key for the Federal Reserve then remains in being able to closely monitor these factors and be able to anticipate any sudden changes and react accordingly by utilizing the many tools that are at their disposal. To conclude, on a very simple note, discretionary fiscal policy fails to instill confidence in the economy. The prolonged operation of unsound banks makes them even more insolvent and inefficient, which in the end increases the cost to be imposed on the taxpayers, creating an environment of mistrust among them.
Insolvent banks existence and practice, particularly pricing, will distort market functions greatly but this will only keep them alive for a few more months. Many banking sectors have learned from experience that the financial condition of weak banks always is much worse than their financial statements indicate and that the cheapest way of keeping a banking system sound is to force the early and regulated exit of nonviable banks. However, to work properly, such a policy requires a system of prompt corrective action. Equipping the masses with higher purchasing power, however, does.
Corporations and individuals alike have to trust themselves first to trust government measures and hence this lends greater credibility to monetary expansion as an exit strategy in the current scenario. The answer, however, clearly lies in the road less travelled. Laissez Faire should be adopted by the world markets in order to address the current economic woes that global economies are facing. Laissez Faire has a distinct advantage because it will allow the emerging markets to reach their full potential without government regulations that stifle their growth.
China will be able to emerge as a legitimate economic global power once the trade restrictions are eased.
Baker, D. (2005). The Federal Reserve Board – The Most Important Source of Poverty in the United States Center for Economic and Policy Research Economics Seminar Series. Baumol, W. and Blinder, A. (2006) Macroeconomics: Principles and Policy, Tenth edition. Thomson South-Western, United States Epstein, L. and Martin, P. (2003). The Complete Idiot’s Guide to the Federal Reserve. Alpha Books. United States