Federal_Reserve

Federal Reserve Sarah Martin ECO 212 January 5, 2010 Nicholas Briscoe Federal Reserve This paper will define the purpose and function of money. It will explain how the Federal Reserve manages the nation’s monetary system. This paper will also outline the stated direction of recent monetary policy in the United States. It will list at least one policy action that the Federal Reserve has taken to confirm that direction. In addition, this paper will explain the effects of monetary policies on the economy’s production and employment. Money is assets that people are generally willing to accept in exchange for goods and services or for payment of debts (Hubbard & O'Brien, 2010). The most common use is cash. When defining the purpose of money, one must define its functions. Money has four functions: money is a medium of exchange, a unit of account, a store of value, and a standard of deferred payment. A medium of exchange is a “commodity, currency, or a financial instrument used in commercial transactions between buyers and sellers as a measure and standard value” (BusinessDictionary.com, 2010). For example, when a person goes to the store to buy groceries he or she pays the cashier with money for the groceries. Money as a unit of account is a measurement used to understand the value of a good or service or a debt. If a coloring book costs $1 dollar and a bed costs $300, the bed may be worth 300 coloring books. This is a unit of account or barter system. One item can have many prices so this function gives buyers and sellers a way of measuring value in terms of money. Money as a store of value is any form of commodity, asset, or money that has value and can be stored and retrieved over time (Investopedia.com, 2010). Stocks and bonds are great examples of this. Deferred payment is money owed that will be repaid at a later date (QFinance.com, 2009). When a student uses a loan to complete college, the bank pays the school the money and the student pays it back after completing school. The central bank for the United States is the Federal Reserve. In 1913, Congress passed the Federal Reserve Act, creating the Federal Reserve System (“the Fed”). The main responsibility of the Fed was to make discount loans to banks to prevent the banks panic (Hubbard & O'Brien, 2010). Because of the Great Depression of the 1930s, an amendment to the Federal Reserve Act gave the Federal Reserve’s Board of Governors boarder responsibility to act. Since World War II, the Federal Reserve has carried out an active monetary policy (Hubbard & O'Brien, 2010). This refers to the actions the Fed takes to manage the money supply and interest rates to pursue its macroeconomic policy goals (Hubbard & O'Brien, 2010). The Fed uses three tools in its monetary toolbox to manage the Unites States monetary System: open-market operations, reserve requirements, and the discount rate (Bankrate.com, 2010). To increase or decrease the money supply, the Fed buys or sells government bonds in open-market operations. Money supply increases when the Fed buys bonds. On the other side, money supply decreases when the Fed sells these bonds. “Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Net transaction accounts in excess of the low-reserve tranche are currently reservable at 10%” (Board of Governors of the Federal Reserve System, 2010). The final tool is discount rate. Sometimes banks need to borrow money from the Fed, these loans are called discount loans. The discount rate is the interest rate the Federal Reserve charges on discount loans (Hubbard & O'Brien, p. 841). The Fed has an outline of the stated direction of recent monetary policy in the United States. “The Federal Reserve has developed a number of tools that will facilitate the removal of policy accommodation and reduce the quantity of reserves held by the banking system at the appropriate time. These tools encompass (1) raising the interest rate paid on excess reserve balances (the IOER rate), (2) executing term reverse repurchase agreements (RRPs) with the primary dealers and other counterparties, (3) issuing term deposits to depository institutions through the Term Deposit Facility (TDF), (4) redeeming maturing and prepaid securities held by the Federal Reserve without reinvesting the proceeds, and (5) selling securities held by the Federal Reserve” (Board of Governors of the Federal Reserve System, 2010). The Federal Reserve confirms the stated direction of monetary policy by increasing purchases of mortgage-backed securities and agency debt. It has taken an expansionary stance by increasing the money supply, attempting to stimulate the economy. Monetary policies have the following effects on production and employment within the economy. Manipulating the real interest rate affects the demand of goods and services as well as unemployment. Lower interest rates will reduce the dollars foreign-exchange value, which raises prices of U.S. exports. In turn, the price of products imported will rise, leading to an increase in aggregate demand in the United States. Domestic firms increase production and employment. In conclusion, this paper has defined the purpose and function of money. It explained how the Federal Reserve manages the nation’s monetary system with its various tools. This paper has also given an outline the stated direction of recent monetary policy in the United States, and it has listed one policy action confirming that direction. Finally, it has explained the effects of monetary policies on production and employment in the economy. References Bankrate.com. (2010). The Fed's monetary policy toolbox. Retrieved from http://www.bankrate.com/federal-reserve/the-fed-s-monetary-policy-toolbox-1.aspx Board of Governors of the Federal Reserve System. (2010, July 21). Monetary Policy Report to the Congress. Retrieved from http://federal reserve.gov/monetarypolicy/mpr_default.htm Board of Governors of the Federal Reserve System. (2010, October 26). Reserve Requirements. Retrieved from http://www.federalreserve.gov/monetarypolicy/reservereq.htm BusinessDictionary.com. (2010). Medium of Exchange. Retrieved from http://www.businessdictionary.com/definition/medium-of-exchange.html Hubbard, R. G., & O'Brien, A. P. (2010). Economics (3rd ed.). Upper Saddle River, NJ: Pearson Education, Inc.. Investopedia.com. (2010). Store of Value. Retrieved from http://www.investopedia.com/terms/s/storeofvalue.asp QFinance.com. (2009). Deferred Payment. Retrieved from http://www.qfinance.com/dictionary/defferred-payment