The Federal Reserve was established by the US Congress to help study and implement monetary policy. The Fed was created to ensure stability in the market, especially in the financial market or banking system. The Monetary Policy of the Federal Reserve aims at reducing the cost of credit so that more people, as well as firms, can borrow money, and in turn improve economic growth (Nelson, 2007).
The Fed and its tools
The Fed has three key tools which it can use to influence monetary policy. They include; Open-Market Operations, Discount Rate, and Reserve Requirements.
Open Market implies that the Fed can not make autonomous decisions over security dealers that it does business with each day (Rogoff, 1985). The choice of the securities dealers to trade with is determined by an open market in which a range of primary securities dealers usually competes. The Fed continually buys as well as sells US government securities that exist in the financial markets, and as a result, influences the number of reserves within the banking system. The buying and selling are aimed at influencing the volume as well as the interest rates.
How Open-Market Policy can be applied during the recession
During the recession, the Fed has to use the Open-Market Operations to vary the monetary base, which are the reserve assets of the central bank. Other financial institutions/banks use the monetary base as a fractional reserve, and therefore, the Fed has to increase the circulating money supply by a significant percentage. This means that the Fed has to increase the total money supply in the market. As a result, the Fed has to buy bonds in the open market to increase the money supply in the market during the recession. This is done by swapping out bonds with cash to businesses and interested individuals. This will increase the money supply and reduce the interest rates since the prices will be pushed higher.
This refers to the price of credit that commercial banks as well as other depository institutions normally pay on short-term loans which they borrow from the Federal Reserve Bank (Rogoff, 1985). Usually, the rates set during the recession are lower as compared to that of the Federal Funds.
How discount rates can be employed to overcome recession
The Fed has to manipulate interest rates on a short-term basis. It has to lower the interest rates to spur economic activity as well as control inflation. The Fed has to set the interest rates below the long-term market rates so that it becomes cheaper for financial institutions to borrow money from the central government, and increase their capacity to lend out money as well as make it cheaper for their customers to borrow money. Besides, this will make it less profitable to save, meaning that firms and individuals will be encouraged to spend. In turn, this will increase the money supply in the economy. When interest rates are lowered, but more money is borrowed and savings fall since more money is spent, stability in the cash flow is achieved, and hence an overall increase in the economic activities is realized (Case, Fair & Oster, 2009). Again this change has to be short-term to avoid raising the levels of inflation.
This is the amount of money in terms of percentage that commercial banks/depository institutions have to preserve against a specific deposit in their bank accounts. The reserve requirements determine the amount of money that financial institutions can create through investments as well as loans. Fed’s Board of Governors normally set the reserve requirements at about 10% (Nelson, 2007). This implies that a bank can lend out most of the money that it holds in deposits for its clients so that it does not hold all the money on hand since it could be costly to have all the money within the bank. As a result, excess reserves are held in accounts or maybe held as vault cash by the Federal Reserve Bank. The aim of the Fed for employing this tool is to make sure that depository institutions preserve the least amount of physical funds in their reserves.
How reserve requirements can be employed during a recession
The Fed exercises regulatory authority over commercial banks. Thus, during the recession, reserve requirements can be put into operation by adjusting the percentage of total assets that every financial institution has to maintain in reserve with the Federal Reserve Bank/central bank. In times of recession, financial institutions require more money to lend their customers as well as to promote cash flow. This implies that the Fed has to decrease the percentage of the reserve requirement so that banks have more money to lend out to their customers against every dollar deposited. This means that financial institutions will be able to increase their available loanable funds against the specified deposit liabilities. However, this adjustment in the money supply aimed at creating a lending multiplier should only be implemented for a specific period (Case, Fair & Oster, 2009).
The Fed employs three primary tools to manipulate monetary policies for accomplishing both short-term and long-term goals. Open-Market Operations, Discount Rates, and Requirement Reserves are all employed to manipulate monetary policies during the recession to increase the money supply in the market.
Case, K.E., Fair, R.C., & Oster, S.E. (2009). Principles of macroeconomics, 9th ed. Upper Saddler River, New Jersey: Pearson
Nelson, E. (2007). Milton Friedman and U.S. monetary history: 1961-2006. Federal Reserve Bank of St. Louis Review, 89 (3): 171. Web.
Rogoff, K. (1985). The optimal commitment to an intermediate monetary target. Quarterly Journal of Economics, 100: 1169–1189