Role of The Federal Reserve Plays In The U.S. Economy

Role of the Federal Reserve Plays In The U.S. Economy

Introduction

The purpose of the essay is to discuss the role of federal reserves in the United States economy. (Mishkin 2005)Also the essay discusses the specific five Macroeconomics concepts that are: Open Market Operations, Discount and Federal Fund Rates, Gross Domestic Product, inflation and The Consumer Price Index, and the Business Cycle. the importance of the topic lies in the fact that the Federal Reserve necessarily uses intermediate indicators in implementing a price-stabilizing monetary policy because of the well-known lags involved as well as the need for occasional pre-emptive action. (Katz 2002)

With a quasi (informal) inflation targeting approach in place, the Fed's intermediate indicators must provide reliable signals of future changes in inflation. (Argo 2006) In recent years, however, mainstream economists (and their favored indicators) have done a relatively poor job of forecasting inflation. Inflation has been routinely overestimated: i.e., forecasted inflation has been higher than actual inflation. "Standard tools" or conventional indicators commonly used for forecasting inflation in many of these models involve the gap between actual unemployment and NAIRU or between actual and potential GDP. In recent years, these policy guides (and models making use of such guides) have faired poorly, persistently overestimating inflation. (Stein 2004)

Open Market Operations

The buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system. Purchases inject money into the banking system and stimulate growth while sales of securities do the opposite.

Open market operations are the principal tools of monetary policy. (The discount rate and reserve requirements are also used.) The U.S. Federal Reserve's goal in using this technique is to adjust the federal funds rate--the rate at which banks borrow reserves from each other. (Volcker 2002)

Open market operations are one of three basic tools used by the Federal Reserve to reach its monetary policy objectives. The other tools are changing the terms and conditions for borrowing at the discount window and adjusting reserve requirement ratios. The execution of OMOs in the "open market"—also known as the secondary market for securities purchases—is the Federal Reserve's most flexible means of carrying out its objectives. By adjusting the level of reserve balances in the banking system through open market operations, the Fed can offset or support permanent, seasonal or cyclical shifts in the supply of reserve balances and thereby affect short-term interest rates and by extension other interest rates. (Mishkin 2005)

Discount and Federal Fund Rates

The interest rate that an eligible depository institution is charged to borrow short-term funds directly from a Federal Reserve Bank. The interest rate used in determining the present value of future cash flows. (Argo 2006)This type of borrowing from the Fed is fairly limited. Institutions will often seek other means of meeting short-term liquidity needs. The Federal funds discount rate is one of two interest rates the Fed sets, the other being the overnight lending rate, or the Fed funds ...