Consistent attempts to expand the economy beyond its potential for production
will result in higher and higher inflation, while ultimately failing to produce
lower average unemployment. Therefore, most economists would argue that there
are no long-term gains from consistently pursuing expansionary policies. The
crowding out of investment is traced to the failure of monetary policy (Eisner
59). Although there are some negatives with monetary policy, it can determine
the economy’s average rate of inflation in the long run. That is important for
the economy, because high inflation can hinder economic growth in a couple of
ways. It adds an inflation risk premium to long-term interest rates and it
complicates the planning and contracting by business and labor that are so
essential to capital formation. High inflation also hinders economic growth in
other ways. For example, because the tax system isn’t indexed to inflation, high
inflation helps and hurts different sectors of the economy. In addition, it
makes people spend their time hedging against inflation instead of pursuing more
productive activities. Because the Fed can determine the economy’s average rate
of inflation, some commentators and some members of Congress have emphasized the
need to define the goals of monetary policy in terms of price stability, which
is achievable. But the Fed, like most central banks, cares about both inflation
and measures of the short-run performance of the economy. However, pursuing
multiple goals can create conflicts for policy. One kind of conflict involves
deciding which goal should take precedence at any point in time. Another kind of
conflict is the potential for pressure from the political arena.
The Fed is somewhat insulated from the pressure of politics by its
independence, which allows it to achieve a more appropriate balance between
short-run and long-run objectives. The Fed will not use monetary policy to help
a region in a recession. Often enough, some state or region is going through a
recession of its own while the national economy is prosperous. But the Fed can
not concentrate its efforts to expand the weak region for two reasons. First,
monetary policy works through credit markets, and since credit markets are
linked nationally, the Fed simply has no way to direct stimulus to any
particular part of the country that needs help. Second, if the Fed stimulated
whenever any state had economic hard times, it would be stimulation much of the
time, and this would mean higher inflation. The Fed can not control inflation or
unemployment directly; instead, it influences them indirectly, mainly by raising
or lowering short-term interest rates. The major tools the Fed uses to affect
interest rates are open market operations and the discount rate, both of which
work through the market for bank reserves. Banks and other depository
institutions are legally required to hold a specific amount of funds in
reserves. Currently, banks must hold 3-10% of the funds they have in interest
bearing and non interest bearing checking accounts as reserves. The amount of
reserves a bank has to hold changes daily. When banks need additional reserves
on a short-term basis, it can borrow them from other banks that happen to have
more reserves than they need. These loans take place in a private financial
market called the federal funds market. The interest rate on the overnight
borrowing or reserves is called the federal funds rate or simply the funds rate.
It adjusts to balance the supply of and demand for reserves. The interest rate
is also used as an indicator of monetary policy and future economic growth (Sims
250). The prime tool the Fed uses to affect the supply of reserves in the
banking system is open market operations. This means the Fed buys and sells
government securities on the open market. These operations are conducted by the
Fed’s open market trading desk at the Federal Reserve Bank of New York. If the
Fed wants the funds rate to fall it buys government securities from a bank.
