The Federal Reserve is an important financial institution in America. Most commercial banks in the country are subject to its control. Even though the main objectives of the institution are stabilizing prices, maximizing employment, and regulating interest rates, the Federal Reserve has recently acquired new duties, including supervising and regulating banking institutions, conducting the nation’s monetary policy, and ensuring the country’s financial system is stable.
Factors that Influence Federal Reserve in Adjusting Discount Rate
The Federal Reserve adjusts interest rates, depending on the performance of macroeconomic indicators such as inflation, exchange rates, balance of payments, economic stability, and the consumer price index. Discount rates affect these macroeconomic indicators by varying the supply of money in the economy. For example, through an increase in the discount rate, inflation and the consumer price index will decrease. Subsequent sections of this presentation show how the discount rate affects other macroeconomic indicators.
How Discount Rates affect the Decision to Set Interest Rates
Commercial banks normally borrow money from the Federal Reserve. Depending on the discount rate, the Federal Reserve may encourage or discourage these commercial banks to borrow money from it. For example, commercial banks would be discouraged to borrow money from the Federal Reserve if the interest rates are high. This is because most of their customers would be equally discouraged to borrow money from them if the commercial banks reflect higher interest rates charged by the federal bank. However, commercial banks have no option but to reflect the Federal rates of lending to their customers, and by extension, the larger economy. Therefore, if the Federal Reserve sets a high discount rate for commercial banks, the commercial banks have to lend money to the economy at a high interest rate as well. Similarly, if the Federal Reserve sets a low discount rate for commercial banks, most commercial banks would set their interest rates at a similarly low rate.
How Monetary Policy Avoids Inflation
Monetary policies have a significant impact on the rate of inflation. For example, when the monetary policy favors a reduction in the federal funds rate, there will be more money flowing through the economy, through cheaper loans and easy access to financing. This development increases the appetite for goods and services in the economy. If the demand for goods and services is very high, it may outstrip the supply of the same goods and services, thereby causing inflation, or an increase in the prices of such goods. Therefore, monetary policies may avoid inflation by controlling the federal funds rate. For example, an increase in the federal funds rate would make it more expensive for commercial banks to offer credit to its customers, thereby reducing the amount of money in the economy. A reduced circulation of money in the economy would consequently create a lower demand for goods and services, thereby reducing the rate of inflation.
How Monetary Policy Controls Money Supply
The Federal Reserve often controls the money supply by targeting interest rates for purposes of promoting economic growth and stability. Depending on whether the monetary policy is expansionary of contractionary, the supply of money in the economy may be affected. Expansionary monetary policies aim to increase money supply, while contractionary monetary policies reduce money supply. Expansionary monetary policies increase the money supply by reducing interest rates, in the hope that more people will borrow money from commercial banks, thereby increasing the circulation of money in the economy. Comparatively, contractionary monetary policies use high interest rates to reduce the supply of money in the economy by discouraging people from borrowing money.
How Stimulus Programs Affect Money Supply
The US has used the economic stimulus program, severally, to improve the welfare of the economy. More recently, the government used the stimulus program to support the automotive industry and the struggling US financial institutions in the 2008 financial crisis. Governments introduce stimulus programs to improve a country’s economic welfare by increasing employment opportunities and the money supply. This happens by sustaining and growing the existing economic sectors. This relationship manifests through the multiplier effect as shown in the following slide
The multiplier effect shows the expected outcomes of the stimulus program because its application increases national outcome through the growth of industries. Therefore, a stimulus program expects to increase money supply by directly injecting money in the economy to stimulate investments and growth in such sectors. This growth equally creates more employment opportunities, increased spending, and the overall expansion of the national income and money supply as well. This is the multiplier effect that supports the outcomes of stimulus programs.
Indicators of Money Supply
Inflation, exchange rates, and changes in price levels are good indicators of money supply. High inflation rates show that there is a high supply of money in the economy because inflation is often characterized by an oversupply of money in the economy. High inflation rates are also characteristic of low interest rates.
Similar to inflation rates, exchange rates also indicate the level of money supply in the economy. Since exchange rates are normally products of the demand and supply model of a currency, a low supply of money in the market increases the value of the dollars. Similarly, when there is a high supply of dollar in the market, the value of the dollar similarly decreases.
Price levels in the economy also demonstrate a similar relationship with money supply because high price levels signify increased supply of money in the economy and low price levels signify a low supply of money in the economy.
How Monetary Policy Adjusts Money Supply Indicators
Commercial banks are required to maintain a percentage of their deposits as reserves. The Federal Reserve normally dictates this percentage of deposits as the reserve requirements. The percentage of reserve requirement normally affects the supply of money in the economy. The higher the reserve requirements, the lower the supply of money in the economy. Similarly, the lower the reserve requirements, the higher the supply of money in the economy.
Monetary policy may also affect money supply through open market operations. Open market operations may include the sale and purchase of government bonds, sale of government securities, or foreign exchange swaps. These open market operations affect the supply of money in the economy because they either increase or decrease the money supply. For example, the sale of government bonds drains money from the economy, as people give money to the government, in exchange of government bonds. Such market operations therefore reduce the supply of money in the economy.
Lastly, a standing facility adjusts the level of money supply in the economy as it controls the borrowing and lending capacities of commercial banks. Standing facilities are designed to offer a financial facility where commercial banks can borrow or deposit funds. The rate of interest charged by these banks are usually flexible enough to allow commercial banks to adjust their liquidity, thereby affecting the supply of money in the economy.
The role of the Federal Reserve in influencing the business environment is mainly limited to maintaining a favorable environment for businesses. Therefore, foreign investors should not be alarmed about the activities of the Federal Reserve as they are mainly complementary and supportive. Therefore, foreign investors should feel welcomed to invest in the country.
Colander, D. C. (2010). Macroeconomics (8th ed.). Boston, MA: McGraw-Hill/Irwin.