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All around the world most people are familiar with the fiscal policy and its tools which effect on demand and move the aggregate demand curve, such as government spending and tax, but many are less familiar with monetary policy and its tools which is conducted by the Federal Reserve System from the year 1913, the nation’s central bank, and it influences demand by increasing and decreasing short term interest rates.
The object of monetary policy is to influence the economy performance as reflected in factors like inflation, economic output, and employment. It works by affecting demand across the economy that is, people’s and firms’ willingness to spend on goods and services.
Monetarist economists believe monetary policy is a more powerful than fiscal policy in controlling inflation. Monetary Policy involves changes in the base rate of interest to influence the rate of growth of total demand, the money supply and price inflation. It also involves changes in the value of the exchange rate since fluctuations in the currency also impact on macroeconomic activity (incomes, output and prices).
Changing in short term interest rate affects the spending and saving behavior of households and businesses over time and thus feed through the circular flow of income and spending. The transmission mechanism of monetary policy works with variable time lags depending on the interest elasticity of demand for different goods and services. For instant the demand for interest sensitive consumer goods and services bought on credit or the demand for capital investment from private sector businesses. Because of the time lags involved in setting an appropriate level of short-term interest rates, the Bank of US sets nominal interest rates on the basis of hitting the inflation target over a two year forecasting horizon.
Monetary policy is a process which the central bank of country (The Federal Reserve) controls the money supply, availability of money, and cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy.
The Federal Reserve Bank which is called FED in abbreviation form is responsible for efficiency of US economy. And the twelve Federal Reserve Banks are a main department of the Federal Reserve System, the central banking system of the United States. The twelve Federal Reserve banks together divide the nation into twelve Federal Reserve Districts, the twelve banking districts created by the Federal Reserve Act of 1913. The twelve Federal Reserve Banks are responsible for implementing the monetary policy set by the Federal Open Market Committee. Each Federal Reserve banks are responsible for the regulation of the commercial banks within their own particular district.
One of the major parts of the Federal Reserve Banks is FOMC. FOMC is The Federal Open Market Committee which is charged under United States law with overseeing the nation’s open market operations. It is the Federal Reserve committee that makes key decisions about the rate of interest and the growth of the United States supply of money. It is the principal organ of United States national monetary policy. (Open market operations are the buying and selling of United States Treasury securities.) The Committee sets monetary policy by specifying the short-term objective for those operations, which is currently a target level for the federal funds rate. The Federal Open Market Committee was formed by the Banking Act of 1933.
Recent economy in U.S.
On January 28th estimated advance growing on real GDP for the fourth quarter of 2010. According to this estimate the GDP of the U.S. Increased 0.784 of 1 percent over its level in the third quarter of 2010. While these increases in real GDP not sufficient to reduce the unemployment. The output recession began with the effective bankruptcy of Fannie Mae and Freddie Mac in September of 2008. That led to the collapse of some financial enterprises and the bailout of others. The collapse did not have to go beyond those firms. However because the declared bankruptcies of Fannie Mae and Freddie Mac by their managements were unexpected by the markets there ensued a widespread panic among stock market investors which led to sharp declines in stock prices. This in turn brought further panic and a loss of consumer and business confidence in the future of the U.S. economy. Business investment in increased capacity is highly volatile. Increase in real GDP between 2010 first semiannual and 2010 second annual was 26 billion more commodity and services. The investment in the plant and equipment by business started to drop in 2008. And recession continued of 2009. This recession reflected declining confidence about the future of economy. But in 2010 the investment in plant and equipment grow up, and back up to $1403.1 billion. Consumers’ purchases in 2010 increased in all categories; commodities and services. The level of personal income was 11,028.7 billion in current value dollars. And this had increased to 11,070.4 billion. The consumer price index for February of 2010 increased by 0.34 of 1 percent over its value in last year to same this month. Reduce in investment is a big problem for macroeconomic and for 2008 crisis was decreasing in residential structures investment, and during 2006 increased fluctuations in inventory investment offset some of the decreasing in residential investment.
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It’s continued during 2007 this decreasing. Whereas between 2008 and 2009 real GDP declined by 3.83 percent and investment in property and equipment declined by 19.7 percent, and declined in this sector was 158 percent of the decrease in GDP in the recession. Other declines was in consumer purchases, but government for recovery this problem started to purchases this policy continued in 2009 and remained in level of 2010. This was largely purchase with government, probably due to reduce on tax revenue. Consumer purchases also tended have a steady and increased during to 2009 and 2010. Purchase in service sector involves a greater amount now.
Currently (2011) the economy is growing but not robustly and there is still weakness in the elements of business investment. Gross Private Investment is still only 77 percent of what it was in the first quarter of 2006. Investment in inventory which was fueling the recovery dropped to a negligible level in the fourth quarter of 2010. The Administration can very easily offset everything that it does to stimulate the growth of the economy by creating uncertainty about its future actions and policies. Uncertainty about government policies strongly discourages investment in plant and equipment.
Current monetary policy of the USA
As we mentioned in past paragraphs US economic recovery is proceeding at a moderate pace and still there are some matters in US economic condition such as high rate inflation, weak investment in non residential structures and housing sector. US Fed for facing with this condition has adopted an expansionary monetary policy. For a clear analysis of their recent monetary policy we study its features, instruments, targets and effects separately. Of course, all contents are based on Fed’s reports to congress or their scheduled meeting express releases.
Monetary policy rests on the relationship between the rates of interest in an economy, that is, the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. In the current U.S. monetary policy Fed has controlled both of the interest rate and supply of money to regulate the economy condition. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Therefore, as FOMC has released in the latest meeting news in 27th April the Committee seeks to foster maximum employment and price stability. Due to this policy and for promoting a stronger pace of economic recovery, the Committee decides to continue expanding its holdings of securities as announced in November. Another matter that has concerned the FOMC is the increasing in the prices of energy and the pushing up of other commodities to inflation in recent months, but the Committee expects these effects to be transitory, however it will pay close attention to the evolution of inflation and inflation expectations. Meanwhile, The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.
In practice, implementation of any type of monetary policy needs to the main tool that used for modifying the amount of base money in circulation. With this policy approach the target is to keep inflation, under a particular definition level within a desired range. The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. The interest rate target is maintained for a specific duration using open market operations. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee. Changing in the interest rate target is responsible to various market indicators in an attempt to forecast economic towards achieving the defined inflation target. Regarding to Fed’s latest statement increases in the prices of energy and other commodities have pushed up inflation in recent months.
Monetary aggregate :
Open market operations:
Reserve requirements policy:
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