The Federal Reserve Essay

The Federal Reserve

Thesis Statement

The stability of the economy of each country is determined by how well the banking sector is regulated. The Federal Reserve has been very keen on how banks in the United States carry out their transactions, and this explains why the economy has been strong in spite of numerous challenges it has faced.

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In the modern world, every country tries to work hard to make sure that its economy is strong and records positive growths annually. In the post 2007-2009 economic recession, numerous measures have been undertaken by various governments to protect their economies from collapsing in the process of economic recession. In the United States of America, the Federal Reserve has been formulating policies aimed at protecting the economy. Being the largest economy in the world, the US Federal Reserve is aware that some of the policies it implements have far reaching consequences on the world economy. Therefore, well-developed policies are important to protect the interests of the other countries. For example, the recent economic meltdown across the world is believed to have started in the United States economy.

1. Evaluate the role and the effectiveness of the Federal Reserve in stabilizing the current economy.

Meltzer (2008), in his studies, argued that the Federal Reserve has the mandate of making sure that inflation in the United States is kept as low as possible. According to him, the United States economy grows at an average rate of 2 to 2.5 percent annually. Although such growth is not enough to enable the economy absorb more in the job market, Meltzeer says that it is a positive effect as it will protect the employed from the prospects of losing their jobs. When the economy is functioning fine and the cost of basic goods is kept low, the prospects of high inflation are minimized. When the inflation rate is kept as low as possible, then the economy will be performing well. It is one thing that the Federal Reserve has managed to achieve for a long period it has existed.  

Federal Reserve has the mandate of regulating interest rates of the commercial banks.  Some of the commercial banks in the country may impose high interest rates that may become difficult for people with loans to service. It may results in banks recording many bad debts in their account, a situation that affects the banking industry and the economy at large. In addition, the Federal Reserve works to supervise the banking industry in the country. The Federal Reserve can decide to investigate the conduct of certain commercial banks suspected to be engaged in money laundering activities. Lloyd (2006) argues that the illegal activities of certain banks can have far reaching effects on the stability of the economy. It has the mandate to check and supervise the directives given to both the non-bank financial institutions and the commercial banks in the United States. It is a function that the Federal Reserve has executed well for many years.

In addition, the Federal Reserve is tasked with regulating the issue of both coin and notes in the economy. The Federal Reserve is supposed to prevent any money from circulating in the economy without its approval. Through its various departments, the Federal Reserve is supposed to investigate any commercial bank suspected in using money in the economy illegally. It is meant to prevent the dollar from losing its value against other international currencies, such as the Sterling Pound and the Euro. When the value depreciates, it not only affects the United States economy, but also other countries whose economy is attached to the dollar. Therefore, in the interest of other economies, the government through the Federal Reserve should make sure that the dollar is protected against any manipulation from the external and internal forces. Similarly to other functions, the Federal Reserve has been equal to the task of protecting the economy from decreasing.

The administration of external reserves is the sole responsibility of the Federal Reserve. In addition, its mandate is to regulate exchange rates of different currencies against the dollar. Although it is dictated by the market, the Federal Reserve works to make sure that the currency exchange rates remains at the recommended levels. Fluctuation of the dollar makes the prices of goods in the international market increase or decrease. Crude oil, for instance, has been affected by such scenarios, which results in fluctuation on prices of the crude oil by-products.

2. Determine which economic indicators the Federal Reserve should analyze so it can better stabilize this particular economy

Stabilization of the economy is very important to any country in the world today. It is the only way to make sure that the economy is headed in the right direction. According to Lloyd (2006), there are a number of indicators that the Federal Reserve should use in its attempt to stabilize the economy of the United States of America. One of such indicators is the Gross Domestic Product (GDP). Gross Domestic Product is the market value of all the services and goods produced in a country within a set timeline, for instance one year. The Gross Domestic Product measures the wealth of the country under consideration by showing how revenues may grow and by outlining the envisaged return on capital. The data released quarterly by the U.S. department of Commerce tries to explain why the Gross Domestic Product increased or decreased compared to the previous quarterly data. Therefore, the Federal Reserve is required to make use of such kind of data to make changes to its monetary policy.

Money supply can also be used to stabilize the economy. Money supply refers to the total amount of money that is in circulation. It includes all the physical currency, such as the bills and coins together with peoples’ deposits in the financial institutions. According to Meltzer (2008), money supply has been used to predict cyclical economic recessions, recoveries and how the stock market is expected to behave. In order to address the money supply concept, the Federal Reserve has been tasked to increase the supply of the money in the economy by bringing down the interest rates in an attempt to stimulate the economy. On the same note, the Federal Reserve may decide to reduce the amount of money in the economy by raising the interest rates when the situation in the economy becomes tense. 

Consumer pricing index (CPI) is another indicator that can be used by the Federal Reserve to stabilize the United States economy. It is used to measure the changes in the amount of money paid for goods and services for a particular month. It is done to establish whether the prices of basic commodities have increased or decreased. The consumer index data is normally released by the United States Department of Labor Bureau of Labor Statistics. The data usually represent the information of a particular area that had been sampled. It is one of the best indicators of inflation, as it forces the Federal Reserve make amendments to its monetary policy whenever there are changes in inflation. From the data collected, the Federal Reserve might decide to initiate changes to either reduce the inflation or maintain the current trend in the economy.

Producer pricing index (PPI) is normally used in tracking the changes in goods producing sectors, including the manufacturing, forestry and agriculture. In addition, producer pricing index controls the price variations for a growing portion of the non-goods producing sector. Webel (2008) has observed that producer pricing index measures the costs of goods during the three stages of production. The three stages are: crude, intermediate and finished goods. The producer pricing index is very important to the Federal Reserve because it is the first indicator of the inflation level in the country. It can be observed by establishing the costs of crude prices used before they can become a finished product.

3. Describe which monetary policies the Federal Reserve might use to influence the money supply

The Federal Reserve has been tasked to regulate the amount of money available in the economy of the country. In order to achieve such objective, it can use the following tools to influence the money supply in the economy. The first is implemented by using the Required Reserve Ratio (r) where it might occasionally change the ratio. The Federal Reserve may direct to all the banks the amount of reserve they may hold, and the amount of money to be lend to clients. According to Masahiro (2012), if the Federal Reserve decides to increase the reserve ratio, the amount of money held as deposit together with money multiplier will be smaller. As a result, the banks become limited on the amount of money that they may supply at any given time. Secondly, the Federal Reserve may use the discount rate where banks borrow their money and pay and repay back the money at an agreed rate called the discount rate. If the Federal Reserve wants to increase the amount of money in circulation, then it may decrease the discount rates. On the other hand, it can increase the discount rate if it wants to limit the amount of money in circulation. Open Market Operation is another option that can be adopted to influence money circulation in the economy. It is normally achieved by buying or selling of government securities through an open market operation. Meltzer (2008) points out that when the Federal Reserve buys the securities, it does so through the amount of money that was not available in circulation. As a result, it works to increase the amount of money flowing in the economy. According to Meltzer (2008), when there is increased level of inflation in the country, the Federal Reserve is forced to reduce the amount of money in circulation by selling the securities and hence, boosting its reserve rate. On the other hand, when the economy is in recessionary gap, the Federal Reserve will avail more money in circulation by buying securities, lowering the reserve rate, as well as bringing down the discount rates offered to commercial banks.  

4. Explain the strengths and weaknesses of using monetary policy in comparison to fiscal policy when promoting economic activity and preserving price stability

Asdel (2012) argues that the main advantage of monetary policy is that it works to keep the level of inflation low. According to him, monetary policy aims at promoting maximum sustainable levels of economic output, in order to maintain an unwavering price system. It is through such stable price system that the inflation rate is kept low. However, the system has been observed to have weaknesses on conflicting goals. Masahiro (2012) points out that the Federal Reserve may use the monetary policy to maintain low inflation, while at the same time affecting the output and employment in the short run. However, such objectives conflict because such move during a recession period could be a catalyst for a future inflation, if expansionary policy remains in place for a long time. On the other hand, fiscal policy refers to the way government expenditures and taxes are utilized to influence the level of economic activity in the country. It can be used in a similar way as monetary policy, since it can be used to reduce recessionary and an inflationary gap.

5. Analyze the effect of the Federal Reserve’s action you identified in #3 on the aggregate demand/supply model

As stated, the Required Reserve Ratio is used by the Federal Reserve to limit the amount of money commercial banks may retain at any given time. Therefore, in an attempt to limit the circulation of money the Federal Reserve increases the demand of the currency, while limiting the supply. Such scenario may increase the value of the dollar against other currencies. By using the discount rate, the Federal Reserve ensures that more people can access credit facilities and hence, the rate of inflation may decrease. In the demand/supply scenario, there should be a balanced demand and supply as the demand for loans is high and the supply is equally available. Open Market Operation helps either increase or decrease the demand and supply of the money in the economy. 


The Federal Reserve has played an important role in protecting the United States economy from decreasing. The measures taken by the Federal Reserve have ensured that the economy recovers quickly inform a possible shock. Other countries should emulate the operations of the Federal Reserve as it can require much time in ensuring the world economy is stable. In addition, the government through the Federal Reserve should control the banks involved in suspicious operations. It is very important as some of business people who evade taxes normally liaise with such banks to cover their illegal activities. In order to discourage such activities, any financial institution claimed to be engaged in fraud should be banned from operating. Such move would act as a warning to other banks who normally engage in similar activities. In the end, the economy of the country would avoid manipulations by such financial institutions.

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