please read the following passage: http://www.federalreserve.gov/newsevents/pres
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Question
please read the following passage: http://www.federalreserve.gov/newsevents/press/monetary/20091216a.htm and help me with these questions: 1)Discuss the Federal Reserve’s use of open-market operations to influence the money supply and the respective consequences of such actions. 2)Discussion of the money multiplier effect in your response. Justify your conclusions and provide appropriate examples. answers should have: Discussed in detail reasons for the FOMC decision to reduce the number of purchases of government securities Discussed the consequences of the FOMC’s decision on the economy. Discussed the Federal Reserve’s use of open-market operations to influence the money supply
Explanation / Answer
The Federal Reserve
In early November 2010, an article from the National Journal summarized the weak state of the national economy, burdened with high unemployment, and then outlined the central bank's prescription to encourage economic growth. The article said this:
'The Federal Reserve, in a much-anticipated attempt to rev up the economy and fend off deflation, launched a new program this afternoon to inject $600 billion into the economy... the policy-setting Federal Open Market Committee said it will create $75 billion in new dollars per month through next June and use them to buy long-term Treasury bonds. The goal is to push down the cost of borrowing for both businesses and consumers, and in turn to increase investment and spending.
In addition, the committee said it would continue to reinvest the proceeds from maturing mortgage-backed securities into Treasury bonds, effectively pumping what is expected to be an additional $250 billion to $300 billion into the economy at large.'
The Federal Reserve is the central bank of the nation, and it's solely responsible for controlling the supply of money in the economy - what economists refer to as 'monetary policy.' Just as this article suggests, monetary policy actions that increase the money supply lead to higher economic output as measured by real GDP.
The Fed uses three main tools that it calls open market operations, required reserves and the discount rate. This lesson covers the first one, open market operations. Let's find out what open market operations are how they work and then see the effect that they have on the money supply using some real-world examples.
In the town of Cello, three people are very interested in what the Federal Reserve is doing: Lydia (a factory worker), Bob (a business owner) and Allison (a retired woman living on Social Security and the savings she has at the bank). Each of them are anxiously awaiting the announcement taking place today by the central bank - an announcement that will affect interest rates and the economy as well as impact them on a personal level.
Open Market Operations
Open market operations are the purchases and sales of government securities in the open market by the Federal Reserve. According to the New York Federal Reserve, which conducts these activities throughout the year, open market operations are the most flexible and frequently used means of implementing U.S. monetary policy.
The Federal Open Market Committee (or FOMC for short) is directly responsible for all open market operations. It's made up of seven Federal Reserve governors plus five Federal Reserve district bank presidents.
Whenever I hear the words 'open market operations,' I imagine a patient in the hospital about to be wheeled in to have open-heart surgery performed. In the physical body, the blood carries oxygen to keep the body alert and strong, and the heart is responsible for pumping this supply of oxygen-rich blood throughout the veins and arteries. Sometimes the heart gets blocked, and this supply can't flow where it's needed. Open heart surgery unblocks the heart so that it can pump the supply of blood needed for survival and good health.
The money supply is the lifeblood of the economy, and the open market operations conducted by the Federal Reserve take place at the heart of the financial system. Their activities ensure that the supply of money flows freely into the hands of consumers and businesses that can use it to invest and make the economy grow.
Why does the Fed want to control the money supply? Because it enables them to control the most basic interest rate in the economy: the federal funds rate. The federal funds rate is the interest rate that banks charge other banks for overnight loans; therefore, it is the most short-term of all the interest rates. When the Fed changes the money supply and alters this most basic interest rate, they indirectly affect all other interest rates. This is what gives them the ability to stimulate economic growth or slow the economy down.
For example, if the Fed buys government securities, they pay with new money that gets added to the reserves of the banking system. This increase in the money supply causes the fed funds rate to go down - let's say from 4% to 3%. Why does that matter? Almost immediately, interest rates on many other financial investments in the economy would go down as well, which means that the Fed has just lowered the price of money for consumers and businesses. Interest rates on credit cards, home equity loans and business loans begin to fall, making it cheaper to borrow, and this in turn stimulates the economy. At the same time, interest rates on savings accounts fall.
In the town of Cello, Lydia, the factory worker, can now take out a home equity loan and upgrade her kitchen - a project she's wanted to pursue for a long time. Bob, the business owner of a lawn service, finds it cheaper to borrow money to invest into his business. These people are happy about lower interest rates.
However, people like Allison are not. Allison depends not only on Social Security checks she receives each month, but on the interest she earns in her large savings accounts at the bank. When interest rates go down, Allison earns a lower return, which lowers her income. She's very disappointed to hear this news. Borrowers love it and savers hate it when interest rates go down, something that happens when the Federal Reserve buys bonds in the open market.
On the other hand, when the economy is growing too quickly and inflation is going up, the Federal Reserve may conduct open market operations by selling government securities, leading to an increase in the fed funds rate, which trickles down to many of the other rates that affect consumers and businesses. In this case, interest rates on credit cards, home equity loans and business loans would rise, creating less of an incentive for consumers and businesses to borrow money. This, in turn, slows down the economic output of the nation. However, interest rates on savings accounts would rise, benefiting savers. Borrowers hate it when interest rates go up, but savers love it.
Although the Fed does not control the demand for money, by controlling the supply of money in the money market, it can set the interest rate wherever it wants in order to stimulate growth in the economy or slow the economy down. Let's take a closer look at what happens to the money supply when the Fed conducts its open market operations.
How does open market operation (OMO) affect economic activity:
OMO refers to the sale /purchase of securities (government) by the FED to other banks, institutional buyers and financial institutions in order to influence the total money circulating in the system? Ina recession when the govt wants consumers to spend more it purchases these securities. This releases more funds into the coffers of these institutions, which allows them to use these to extend more credit and raise consumption and investments. The opposite happens in a boom period. When the government wants to reduce spending and arrest rising prices it takes away funds by offering to sell its own securities. Financial institutions buy these and reduce the amount left with them for credit purposes. Since the FOMC is the policy making branch of the FED it is responsible for any decisions on sale/purchase of securities as well as the price at which these transactions happen. The article is a part of that decision making. It outlines the decisions taken and elucidates the reasons behind the former. Therefore the influence on the economy of OMO is via changes in money supply.
Reasons for the FOMC decision
recent data has been encouraging on a front of fronts, which signaled a recovery from the financial meltdown of 2009. But this recovery was slow compared to most recoveries from previous recessions. Signs of a recovery include:
In the residential real estate sector, home sales and construction were rising, from their earlier low levels- in some areas prices had even raised.
Inventories were reducing at slower rates, which meant greater confidence in consumption spending by firms.
The trend for consumer spending showed an uptrend.
There was no rise in inflation, so price rise was subdued.
Growth in foreign countries were was on an upswing, which meant greater demand for US exports-a good omen for growth.
However all data was not so positive and bullish on recovery. There remained certain areas of concern:
Unemployment was still high and labor markets were weak.
Bank credit did not rise, which meant that either banks don t have funds or consumers are not picking up loans.-this is a not conducive to a recovery which must be based on rising credit demand that fuels consumption and fresh investments.
Business sentiment was still weak and did not encourage fresh investments. Sentiments affect producers, decisions about capacity expansion, labor recruitment new businesses.
Commercial real estate was not picking up. This is critical as a rise in demand for commercial space shows greater confidence in economic conditions that prompt new businesses to be set up.
These mixed data were the motivation for the decision to continue with purchases of securities. Since the signs of recovery are there the pace of purchases has been reduced. There was a consensus that govt support in terms of pumping money in the economy is still needed to strengthen the initial signs of recovery.
Consequences of FOMC actions:
The estimates and expectations have come true in some respects. Most recent data show a fall in unemployment in USA. However we must understand that OMO have a short, medium and long term effects. Some effects are there to be seen but most of such effects take time to show in concrete data terms. The collection, compilation of data is time consuming. It is clear that USA is recovering from the recession- things are improving. The FOMC s actions have been helpful as witnessed in the EU support o Greece. The govt s monetary support has been instrumental in the recovery. This support translates into the actions of the FOMC and provides a signal that the govt is ready to take any action to force an economic recovery.
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