The Fed Game
The Federal Reserve maintains the interest rate the most important to the economy being the Federal Funds Rate, and thus the Fed uses the influence it has on the Federal Funds Rate to achieve monetary policy.
Inflation determines the price stability of an economy which is a primary goal of the Federal Reserve. Credit management helps maintain inflation at reasonable rates, and it also plays the biggest role in money supply thus the Fed use it to regulate inflation. Inflation has an impact on the employment rates in a country. Credit expansion promotes economic growth which in turn leads to the creation of employment. The three objectives of the Federal Reserve include fair long-term interest rates, price stability and maximum employment, However, price stability is the main goal of the Fed because achieving it translates to achieving all the three objectives.
The Fed’s goal is to keep unemployment at an acceptable natural rate in this case it is set at approximately 5%. An unemployment rate of 0% is undesirable because it means the labor market has to be inflexible. An inflexible labor market makes it hard for people to venture into better jobs because of the challenge of quitting form their current jobs. Economic activity is bound to fluctuate over time. Expansion and recessions are part of the business cycle and during the period, employment increases and decreases respectively. Attaining an unemployment rate of 0% means that the economy cannot fluctuate which is unrealistic.
Regarding inflation, the Fed’s seeks to maintain it at a reasonable rate so that economic growth is not affected. Low interest rates negatively impact the economy by slowing its growth. 0% inflation means low investments by companies as the returns are equally low. Eventually, businesses shut down operations because of reduced profits leading to increased unemployment.
Financial and monetary conditions of the U.S economy are pegged on the Federal Funds Rate which widely affects inflation, growth, and employment indicators of a healthy economy. Reserve requirements are a must for banks and when the requirements are not met, banks are allowed to borrow from each other. The borrowing interest rate among the financial institutions is termed as Federal Funds Rate and it has an impact on the monetary policy which in turn affects the economy. A decrease in the Federal Funds Rate decreases interest rates and results to an expansionary monetary policy which is characterized by increased consumer purchasing power, increased borrowing bin the private sector and low unemployment. Overall, a low fed funds rate increases money supply and this promotes economic growth. On the other hand, an increase in the Fed funds rate increases interest rates leading to a contractionary monetary policy. The policy is defined by a rise in unemployment and reduced consumer spending. With contractionary monetary policy, money supply decreases and this slows down economic growth. (Engen, Laubach, and Reifschneider, 7)
The Fed chair doe not set monetary policy rather he or she guides the board on Federal open market committee (FOMC) on the directions to take to achieve an understanding. Meeting agendas are also set by the chair.
Money supply is controlled by Fed. The impact the Fed’s fund rate has on monetary policy is what determines money supply in the economy. Once monetary policy is set, it will be easy to interpret whether money supply is high or low.
The Federal Reserve Bank sets an administered rate which is different from the market interest rate. The administered rate is termed as the discount rate. Discounted cash flows use the discount rate to analyze future cash flows by determining their present value. Therefore, having the discount rate in the game will not add value to its purpose.
Engen,Eric M., Thomas Laubach, and David Reifschneider. "Themacroeconomic effects of the Federal Reserve`s unconventionalmonetary policies." (2015).
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