The Fed then pays for the securities by increasing that bank’s reserves. As a
result, the bank now has more reserves than it is required to hold. So the bank
can lend these excess reserves to another bank in the federal funds market.
Thus, the Fed’s open market purchase increases the supply of reserves to the
banking system, and the funds rate falls. When the Fed wants the rate to rise it
does the reverse by selling government securities. The Fed gets the payment in
reserves from banks, which lower the supply of reserves in the banking system,
and funds rate rises (Segalstad 1). Banks also borrow reserves from the Fed at
their discount windows, and in that case the interest rate they must pay on this
borrowing is called the discount rate. The total quantity of discount window
borrowing is called the discount rate (World 68). The discount rate plays a role
in monetary policy because, traditionally, changes in the rate may have signaled
to markets a significant change in monetary policy. A higher discount rate can
be used to indicate a more restrictive policy, while a lower rate may signal a
more expansionary policy. Therefore, discount rate changes are sometimes
coordinated with FOMC decisions to change the funds rate (Rukeyser 114). A final
tool of monetary policy are foreign currency operations. Purchases and sales of
foreign currency by the Fed are directed by the FOMC, acting in cooperation with
the Treasury, which has overall responsibility for these operations. The Fed
does not have targets, or desired levels, for the exchange rate. Instead, Fed
intervention aims to counter disorderly movements in foreign exchange markets.
Intervention operations involving dollars, whether initiated by the Fed, the
Treasury, or by a foreign authority, are not allowed to alter the supply of bank
reserves or the funds rate. The process of keeping intervention from affecting
reserves and the funds rate is called the sterilization of exchange market
operations. These are not used as a tool of monetary policy.
The Point of implementing policy through raising or lowering interest rates
is to affect people’s and firm’s demand for goods and services. For the most
part, the demand for goods and services is not related to the market interest
rates quoted on the financial pages of newspaper, known as nominal rates.
Instead, it is related to real interest rates—nominal interest rates minus the
expected rate of inflation. Monetary policy can affect real interest rates in
the short run. Changes in real interest rates affect the public’s demand for
goods and services mainly by altering four things: borrowing costs, the
availability of bank loans, wealth of households and businesses, and foreign
exchange rates. Lower real rates and a healthy economy may increase bank’s
willingness to lend to businesses and households. This may increase spending,
especially by smaller borrowers who have few sources of credit other than banks.
Lower real rates make common stocks and other such investments more attractive
than bonds another debt instruments; as a result, common stock prices tend to
rise. Households with stocks in their portfolios find that the value of their
holdings has gone up, and this increase in wealth makes them willing to spend
more. In the short run, lower real interest rates in the US also tend to reduce
the foreign exchange value of the dollar, which lowers the prices of the exports
sold abroad and raises the prices of foreign produced goods. Expansionary
monetary policy also raises aggregate spending on US produced goods and services
by improving the balance of trade. A monetary policy that constantly attempts to
keep short-term real rates low can lead to high inflation and higher nominal
interest rates to protect the purchasing power of the funds due to them. This is
the reason that economic activity can not keep expanding beyond its potential
level.
Initially, the low real interest rates will cause business and households to
increase their borrowing demands, and that will push up other longer-term
interest rates. These tighter credit conditions will tend to cause real interest
rates to rise despite the Fed’s attempts to keep them low, thereby slowing
economic activity, moving it back toward its potential level (Eisner 25). The
precise magnitude and timing of the effects of the Fed’s actions on the economy
are never perfectly predictable. This is partially because the future course of
the economy is subject to many influences beyond the Fed’s control, such as
government taxing and spending policies, the availability of natural resources
like oil, economic developments abroad, financial conditions at home and abroad,
and the introduction of new technologies. In addition, human responses to
economic incentives are inherently difficult to predict, and may change over
time, leading to errors in predicting private aggregate spending (Rukeyser 124).
Monetary policy alone cannot perform an economic miracle. It cannot eliminate
all fluctuations of the business cycle; it cannot revitalize an outdated
industrial machine; it cannot reform and reduce an overblown, arrogant
bureaucracy; but it can perform stabilizing functions crucial to the economy of
the United States of America. Justin McVay Period 4 Macroeconomics Term Paper
FEDERAL RESERVE AND MONETARY POLICY Monetary policy affects the economic and
financial decisions of virtually all of us from workers to borrowers to
investors (Rukeyser 105).
