Date sent:        Tue, 14 May 1996 16:58:37 -0700

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<br><i>Uploader </i>: TJ
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<br><i>Language </i>: ENGLISH
<br><i>Subject </i>: FINANCE/ECONOMICS
<br><i>Title </i>: MONETARY POLICY OF THE FEDERAL RESERVE
<br><i>Grade </i>: A+
<br><i>System </i>: GRADUATE SCHOOL
<br><i>Age </i>: 35
<br><i>Country </i>: USA
<br><i>Comments </i>: 10 PG PAPER FOR BUSINESS STUDENTS
<br><i>Where I got Evil House of Cheat Address </i>: NETSEARCH
<br><i>Date </i>: 5/14/96

MONETARY POLICY OF THE FEDERAL RESERVE, GUIDING THE ECONOMY



I. WHAT IS THE FEDERAL RESERVE?

 The Federal Reserve System is the central bank of the United 
States.   It acts as the nationÆs banker as well the primary supervisor 
of the nationÆs banks.  Its primary function is formulating, 
implementing and supervisi
ng national monetary policy, which is carried out by the Federal Open 
Market Committee (FOMC).

 A Brief History
 President Woodrow Wilson signed into law the Federal Reserve Act 
on December 23, 1913.  At a time when the U.S. economy was expanding, 
the Federal Reserve system was created to halt the economic chaos.  
Although the Fede
ral Reserve system has operated as the central bank of the U.S. since 
1913, it was not the first central bank of our country.  In 1791, 
Alexander Hamilton issued a twenty year charter for the Bank of the 
United States, th
e first central bank of the U.S.  In the late sixteenth century, the 
primary industry in the U.S. was agriculture.  Historically, there has 
been great mistrust between agrarian enterprises and banking.  The idea 
of a cent
ral bank with extensive economic power was not well received by the 
majority of the U.S. population.  In 1811, the charter for the Bank of 
the United States was up for renewal and was voted down by congress.  
In 1816 Cong
ress created the Second Bank of the United States.  It too was 
chartered for twenty years, and was more powerful than the first 
central bank.  With its additional power it was also met with 
significant opposition.  Its ch
arter expired in 1836.  After the termination of the first two central 
banks the country went into periods of economic chaos.  
 From the end of the Civil War through the turn of the century the 
U.S. economy grew at tremendous rate.  The National Banking Act of 1863 
created national banks and gave them the sole privilege of note 
issuance.  This pu
t an end to state bank issued currency and created a much more stable 
currency.  Each of the national banks held their own reserves which was 
not easily transferred from an institution with excess reserves to 
another inst
itution with a greater demand.  This immobility and long response times 
in moving reserves to where they were needed exaggerated economic 
downturns and brought about panic situations.  Economic depressions 
resulted in 187
3, 1893 and 1907.    
 The Federal Reserve Act provided for a central bank with a board 
made of government appointed directors, none of which could be private 
bankers.  Currency issued by the branch banks would be the obligation 
of the governm
ent, not the branch banks.  The act authorized no less than eight 
regional banks but no more than twelve.
 In November 1914, the twelve regional banks began operations.  
National banks were given sixty days to decide whether they would join 
the Federal Reserve System, membership was voluntary.  Ninety nine 
percent of national
 banks decided to join within the sixty day period as well as some 
state banks.



 Structure of the Federal Reserve System

 The primary function of the board of governors is the development 
and supervision of monetary policy through the Federal Open Market 
Committee (FOMC).  It has supervisory powers over various depository 
financial institut
ions and several consumer credit regulations.  The board of governors 
operates the nationÆs payment system and has oversight responsibilities 
of the twelve district banks.
 Federal Open Market Committee (FOMC)
 ôThe FOMC consists of twelve members, which include all seven 
members of the board of governors; the president of the Federal Reserve 
Bank of New York (a permanent member); and, on a rotating basis, 
presidents of four di
strict banks, each serving a one year term.ö   Annual monetary targets 
are usually set at the first meeting of the year.  At subsequent 
meetings, goals are reviewed and adjusted as necessary to keep 
established targets in
 sight.  
 Goals of the Federal Reserve
  The Federal Reserve seeks a strong economy, minimal inflation 
and full employment.  In addition to these long term goals, the Fed has 
two other major functions.  First is its role as the ôlender of last 
resortö - the Fe
deral Reserve is the ultimate safety net for the U.S. banking system.  
The second priority is to guard against severe currency depreciation.  
The following is a discussion of the tools that the Fed can employ in 
pursuit o
f  its long term goals.  


II.     THE TOOLS AVAILABLE TO THE FEDERAL RESERVE

 Changes in Reserve Requirements

 All financial depository institutions operating in the United 
States are required, under the Depository Institutions Deregulation and 
Monetary Control Act of 1980, to meet reserve requirements set by the 
Federal Reserve.
  Changes in the reserve requirements will either add to or subtract 
from the available loanable funds. Higher reserve requirements will 
reduce available loanable funds while lowering reserve requirements 
will increase av
ailable loanable funds.  The desired effect being either an increase or 
decrease in economic activity.  During periods of sluggish economic 
activity an increase in available loanable funds would help to 
stimulate the econ
omy.  In a recession, defined as at least two consecutive quarters of 
negative GNP growth, the Federal Reserve would stimulate credit 
expansion by increasing bank reserves, prompting interest rates to 
fall.  An increased 
amount of loanable funds becomes available for business and consumer 
borrowing.  As business activity picks up, firms increase hiring, and 
the unemployment rate falls.  While in an overheated economy, a 
decrease in availa
ble loanable funds would serve to slow the economy and hold down 
inflation.  In an inflationary period when the CPI is running at a 5% 
rate or higher and the economy is booming, the Federal Reserve acts to 
cool the econom
y by decreasing bank reserves.  With fewer funds available, interest 
rates tend to rise. These higher rates discourage borrowers - both 
corporate and consumer - and slow economic activity.

 Federal Open Market Operations

 Desired changes in the money supply can be achieved through what 
is known as open market operations.  By selling or buying government 
securities to/from the banks, the Fed can increase or decrease the 
amount of loanable 
funds.  As banks are required to purchase these securities, a portion 
of their vault cash and their reserves on deposit with the Fed would be 
replaced with government securities, a less liquid asset.  This serves 
to reduc
e the amount of loanable funds available for customer borrowing and 
would cause the economy to slow down.  Conversely, if the Fed was to 
purchase government securities from the banks, more loanable funds 
would become avai
lable acting as a stimulus to economic activity.

 The Discount Rate

 Adjusting the discount rate is a another tool that the Fed has 
available to affect the desired impact on economic activity levels.  
The discount rate is the interest rate charged to member banks when 
they borrow directly
 from the Federal Reserve.  As with the other monetary tools already 
discussed, controlling interest rates can bring about the desired 
effect of either increasing or decreasing the money supply.  When the 
discount rate is
 raised or lowered, almost all other short term interest rates follow 
suit and rise or fall. Lowering interest rates would serve to stimulate 
the economy, while raising interest rates would reduce economic 
activity.  A ch
ange in the discount rate sends the strongest signal, of all monetary 
policy tools, as to the direction of the FedÆs monetary policy.

 Moral Suasion
 Often called ôopen - mouth operationsö, moral suasion is a 
monetary policy tool that is only marginally successful.  By exhorting 
the general public to alter its spending and investment habits, the Fed 
along with other c
entral economic figures in the government, try to achieve economic 
policy goals.  To be successful, moral suasion must be supported by a 
convincing argument from credible government officials.  Although moral 
suasion is s
till employed as a monetary tool, it is not considered to be a 
significant tool.	

III.    INDICATORS THAT GUIDE FOMC ACTIONS
 GNP Growth
 ôGross National Product is the most important economic 
indicator.ö   It is the best single measure of U.S. economic output and 
spending.  GNP is the sum total of goods and services produced by the 
United States.  There a
re four major components included in the GNP accounts: consumption, 
investment, government purchases and net exports.  GNP = C + I + G + 
(X-M), where X  = exports and M = imports.	



 Inflation
 To measure inflation, the Bureau of Labor Statistics (BLS) 
measures prices of goods and services at the consumer level.  The 
consumer price index is the most widely used measure of inflation.  
Since it is an index number
, it compares the level of prices to some base period.  Currently, the 
base period is the average level of prices that existed between 1982 - 
1984, which is set to equal 100. Comparing the level of the index at 
two differ
ent points in time, illustrates how much prices have risen in the 
interim.  The index is comprised of 364 consumer items that are 
weighted according to a survey of consumer expenditures. 







 Money Supply
 The Federal Reserve attempts to regulate the pace of money 
expansion in order to move towards its ultimate objective of stable, 
non-inflationary economic growth.  There is little room for Fed error 
here.  If money expand
s too slowly, the economy will not have sufficient liquidity to grow at 
the desired pace.  If money expands too rapidly, the result will be a 
pickup in the rate of inflation.  Effectively, the rate of money growth 
is a ke
y element in the FedÆs monetary policy decisions.

 The Dollar
 By its control of short-term interest rates, the Federal Reserve 
has some degree of influence over the U.S. dollar.  In general, higher 
rates tend to boost the currency, as global investors seek the highest 
possible yiel
d.  Rising U.S. rates, relative to foreign rates, tend to encourage 
investment in dollar denominated assets.  When U.S. rates are declining 
(as they are currently) relative to those overseas, investment flows 
toward other
 countries and other currencies.

 Implementation
 Upon analyzing the aforementioned economic data, the Fed proceeds 
to set the monetary policy targets for the economy.  The FOMC issues a 
directive to the Federal Reserve Bank of New York stating its policy.  
The open mar
ket desk is charged with the responsibility of carrying out that 
policy.  As a permanent member of the FOMC, the president of the 
Federal Reserve Bank of New York would be aware of the intent of the 
FOMC,  and would under
take open market operations to facilitate this directive.

 The actions of the Federal Reserve have far reaching 
ramifications.  When we consider the future course of the economy and 
inflation, consideration must also be given to the likely response of 
the Federal Reserve Bank to
 these developments, which will have implications for interest rates.  
Fixed income markets are directly linked to interest rates.  The stock 
market is tied to corporate profits plus the economy, inflation and 
interest ra
tes.  The dollar depends on U.S. interest rates relative to overseas 
rates.  It is likely that the Fed will continue, as the FedÆs favorite 
operating clichÚ states, to ôlean against the windö.
