Federal Reserve and Monetary Policy of USA

Topic: Banking
Words: 1145 Pages: 6

Why was the Federal Reserve created?

There were chains of bank failures in 1907. Congress felt that the nation required a government institution mainly to supervise the banking system and to police the quantum of monetary supply in the financial system. Hence, Fed was established in the year 1914.

What are its essential functions?

The main function of Federal Reserve is to supervise the banks and to make sure that the fitness of the banking system is at expected levels.

Fed is monitoring financial health of each bank in the country and helps banking transactions to be carried out smoothly by clearing checks. It also functions as banker’s bank by advancing loans to banks when they need. Fed functions as a lender of last resort when a bank is in jeopardy mainly to maintain stability of the overall banking system of the nation.

Who are the decision makers of the Federal Reserve?

Federal Reserve is managed by its panel of Governors with 7 members on the Board who are selected by the President of the U.S.A and affirmed by the Senate. A chairman is being selected from the seven members of the board and is appointed by the President. The Chairman directs the Fed, chairs the board meeting, give evidence before congressional committees about Fed policy whenever necessary.

How do these people obtain these positions?

Federal Board governors including its chairman is selected and appointed by the President of U.S.A and is approved by the Congress. The board members of the 12 regional Federal Reserve Bank are being selected from the region’s business and banking committee. The president of regional banks is selected by the board of directors of the each regional bank.

How does the Federal Reserve control the monetary system?

One of the main goals of Fed is to control the quantum of money that is prevalent in the economy. Fed controls the monetary system mainly through three mechanisms namely

Operations through Open -Market

Fed buys bonds from the public mainly to increase the money supply. To decrease the money supply, public are offered bonds by Fed.

Reserve Requirements

By this, Fed regulation requires a least quantum of funds known as reserves that banks must have in proportion to their deposits. If reserve ratio is increased, then it lowers the money multiplier and decreases the money supply in the economy and vice versa.

Discount Rate

It denotes the interest rates on the loans that Fed advances to banks. The Fed can alter the supply of money in the economy by changing the discount rate.

How do banks increase the money supply?

For every dollar deposited into a bank, a prescribed percentage of reserve is created by a bank. The balance amount is being lent to its customers. If lent out money is spent on purchase of product and if the seller again deposits the same in a bank, then again a percentage of such deposit is kept by the bank as reserve. The quantum of money that a banking organization creates with every dollar of deposits or reserves is known as ‘Money Multiplier.” By lowering the reserve requirements which again decreases the reserve ratio, increases the money multiplier and thus raises the money supply in the economy.

How is inflation measured?

An increase in the overall intensity of prices is known as inflation. Economist evaluates the rate of inflation as the proportion of change in the GDP deflator, the consumer price index or some other index of the aggregate of price level. These price index demonstrate that over the past six decades, prices have increased on mean about five percent per annum. If you calculate the accumulation of price increase over so many years , a five percent of annual inflation rate would result in an eighteen times increase in the price level.

Let us assume P is the price level as measured by the GDP deflator. Then, P indicates the number of dollars required to purchase some quantity of products or services. Thus, the quantum of products and services that can be purchased with $1 is equal to 1/P. If overall price level increases, the value of money declines.

What are the causes of inflation?

As per the quantity theory , the quantum of money present in an economy decides the value of money and sudden growth in the supply of money leads to inflation, To much money chases too few goods is the famous maxim about the cause of inflation. Hence, a central bank must exercise a stringent control over the money supply to avert inflationary trends in the economy.

Are natural disasters causes of inflation or deflation?

A sharp change in the level of probable output may cause inflation. For instance, if significant portion of a nation’s business and factories is destroyed due to natural disaster, then it may lead to inflation.

Further, in cases of natural disasters like earthquakes and hurricanes, there may be unusual or large demand for some goods and services and due to price gouging, inflation may be witnessed.

Where might the public see the evidence?

In 1970’s, prices rose by seven percent per annum which implied a replicating of price level over the decade. Often, public view such high rates of inflation as a crucial economic concern. In January 1921, in Germany, the price of a newspaper rose from 0.3 cents to a whooping 70,000,000 marks. In 1990s, due to international sanction imposed on Serbia, a Snickers bar costs nearly 6 million dinars.

What are the costs of inflation?

During inflation, the cost of minimizing one’s money holdings is known as the Shoeleather cost of inflation. However , in case where there is hyperinflation as it happened in Bolivia in 1985, the citizens did not want to keep pesos as it lost its value and converted it either as goods or into US $ which they thought offer more store of value.

During inflation, prices oscillate frequently. Hence, business firms have to charge different prices as the cost of goods changes frequently and there are cost involved for changing prices. These costs of price adjustment are known as menu costs.

Thus, the cost of inflation is more delicate. Apart from Shoeleather, menu costs, there are other cost of inflation like unintended changes in tax liability, increased variability of relative prices, inconvenience, confusion and arbitrary redistributions of wealth.

Why inflation is so widely feared?

During inflation, money loses its original value. One has to spend more to buy the same quantity of a commodity during inflation. Too much of money chases too few goods. Inflation may lead to higher unemployment and fall in production. Thus why, inflation is widely feared.

Many are of the fallacy that inflation makes them poorer since it increases the cost of what they purchase. Due to Fisher’s effect, during inflation, nominal income also increases which offsets the ill effect of inflation.

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