Federal Reserve Essay, Research Paper
Greenspan and the Federal Reserve: Methods and Resources
The United States of America was founded as a capitalist nation dependent on independent trade by privately owned businesses. This system of economics stays as far away as possible from a centralized government controlled economy. However, as generations of economists, politicians, and businessmen carried out the principles of the Constitution, it became apparent that some centralized bank was required to maintain stability and order in the national economy. This central bank is known as the Federal Reserve, and its Chairman is responsible for maintaining a positive economy through several powers. The current Chairman is Alan Greenspan, a man responsible for controlling a stable economy through several checks and balances.
The Federal Reserve was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. Today the Federal Reserve’s duties fall into four general areas: conducting the nation’s monetary policy; supervising and regulating banking institutions and protecting the credit rights of consumers; maintaining the stability of the financial system; and providing certain financial services to the U.S. government, the public, financial institutions, and foreign official institutions. It consists of twelve regional banks that are owned and controlled by member banks in their region. Overseeing the twelve regional banks is the seven member Board of Governors based in Washington. The primary policy making body in the Federal Reserve is the Federal Open Market Committee (FOMC). The FOMC has twelve members, all seven governors and the presidents of five regional banks (Martin 23-25).
The Fed has three tools it can use to moderate the economy. The most common one is open market operations. Open market operations is just the selling or buying of government securites on the open market. The second tool is the discount rate. The Fed can raise or lower the interest rate it charges other banks for overnight loans. The third and most powerful tool is the reserve requirement. The reserve requirement is the percentage of deposits that a bank is required to have in cash (Grieder 47).
Open market operations affect the economy by increasing or reducing the supply of money. If the Fed wants to increase the supply of money (thereby reducing interest rates) it will buy government securities on the open market. The Fed is then replacing government securities, which are not counted in the primary money supply, with money. To reduce the supply, the Fed does just the opposite, selling government securities (Grieder 48-49).
The discount rate is the amount of interest the Fed charges banks for overnight loans. The Federal Reserve sets a percentage of deposits that all banks must keep in cash, this is called the reserve requirement. If a bank loans out to much money, they have to borrow from the Fed to meet the requirement. If the discount rate is lower than the rates banks can charge on loans, they will loan out more money, increasing the money supply. If the discount rate is higher, banks will loan out less money (Grieder 50).
The reserve requirement is a percentage of deposits that banks are required to hold in cash. If the reserve requirement is high, banks must keep more money in their vaults, instead of loaning it out. If the reserve requirement is low, banks can make more loans and increase the money supply (Grieder 50-51).
The independence of the Federal Reserve is considered crucial to the success of our economy. If Congress or the President had more control over the Federal Reserve they might seek to alter policy for their own gain. For example, a president might choose to relax credit restrictions to spur growth during an election year, regardless of the inflationary consequences. The independence of the Fed prevents this. In 1992, President Bush wanted the Fed to encourage growth, regardless of the consequences. Alan Greenspan and the FOMC refused, knowing it could be harmful to the US Economy. Likewise, if the members of the Board of Governors had to worry about re-election, they might not make the right choices for the long term (Woodward 112-113).
The whole idea of a Federal Reserve is an example of Keynesian Economics. John Maynard Keynes had a significant impact on the post world-war economy. Keynesian Economics also played a role in bringing about an end to the Great Depression. According to Keynes, the government’s duty is to act as employer of last resort during a time of recession. Keynes believed in an extended business cycle, with periods of high employment oscillating with periods of low employment. During times of low employment, the government should spend money, even if it means creating a deficit. A primary problem during a recession is not the lack of money, but the lack of demand. In other words, people have money, but they’re not spending it. According to Keynes, the government can spur demand by spending. Example: During a recession, the government signs a contract to buy 200 fighter planes. The manufacturer of the planes then must hire additional workers. The workers, now that they are employed are going to begin spending more money. This spending will lead other businesses to hire more workers. This is the primary argument against a balanced budget amendment that would require the federal government not to run a deficit. During a time of recession, tax revenues will be down. In order for the government to spend and create demand, they must run a deficit. The risk of Keynesian philosophy is “crowding out” when government spending can harm private business. Crowding out occurs when the government releases bonds to finance deficit spending. These bonds compete with corporate bonds on the open market and may prevent private borrowers from raising the money they need (Theories).
Another principle behind the Federal Reserve is the Phillips curve. Named for economist William Phillips, the Phillips curve demonstrates an inverse relationship between inflation and unemployment. Its main implication is that low inflation and low unemployment are incompatible. This theory holds true most of the time, but has had some significant failures. Most recently in the US, we had high inflation and high unemployment during the administration of Jimmy Carter. And during the Bush and Clinton administrations, largely due to Alan Greenspan we have achieved low inflation and “frictional unemployment”. Frictional unemployment occurs when everyone who wants to be employed is (Mullins 89).
Fiscal policy refers to the method of using spending and taxation to control the economy. Fiscal policy gives governments the ability to regulate economic growth by attempting to influence demand. If the government raises taxes, people will have less money to spend, therefore reducing demand. If the government lowers taxes, people will be more inclined to spend money. The government can also spend money to influence demand, as explained above. Taxation is especially powerful with regards to capital gains. If the government reduces the capital gains tax, more people will be likely to invest. Investments spur production and employment (Mullins 93-95).
Monetary policy attempts to influence the economy by controlling the money supply. This is another aspect of the economy controlled by the Federal Reserve. Monetary policy can influence the economy by altering interest rates. By reducing the supply of money, monetary policy can raise interest rates and discourage lending. Decreased lending results in less investment and less production. By increasing the supply of money, the opposite will occur. Monetary policy in the US is controlled with the use of three tools. They are open market operations, the discount rate and reserve requirements (Grieder 68-71).
Open market operations affect the economy by increasing or reducing the supply of money. If the Fed wants to increase the supply of money (thereby reducing interest rates) it will buy government securities on the open market. The Fed is then replacing government securities, which are not counted in the primary money supply, with money. To reduce the supply, the Fed does just the opposite, selling government securities (Mullins 101-104).
The discount rate is the amount of interest the Fed charges banks for overnight loans. The Federal Reserve sets a percentage of deposits that all banks must keep in cash; this is called the reserve requirement. If a bank loans out too much money, they have to borrow from the Fed to meet the requirement. If the discount rate is lower than the rate banks can charge on loans, they will loan out more money, increasing the money supply. If the discount rate is higher, banks will loan out less money (Woodward 106-108).
The reserve requirement is a percentage of deposits that banks are required to hold in cash. If the reserve requirement is high, banks must keep more money in their vaults, instead of loaning it out. If the reserve requirement is low, banks can make more loans and increase the money supply (Mullins 99-101).
Another method Greenspan and company use is price control. Price controls occur whenever the government tries to set a price above or below the market price. They are refereed to as price floors and price ceilings. A price floor is a legal minimum price set above the market price. An example is minimum wage. Minimum wage sets a higher hourly wage then most employers would normally pay. This has the effect of reducing the number of jobs, because employers will have to pay more for the same work. With a higher price on labor, employers will demand fewer workers. Price ceilings have the opposite effect. They are a legal maximum price normally set beneath the market price. Rent controls are a perfect example. When the government sets a maximum rent, landlords are likely to find another way to make money with their property. The government lowers the price, so landlords will be willing to supply less room for rent (Martin 67-68).
Martin, Justin. Greenspan: The Man Behind the Money. Perseus Press, New York: 2000.
Woodward, Bob. Maestro: Greenspan s Fed and the American Boom. Simon & Schuster, New York: 2000.
The Theories of John Maynard Keyes. http://www.bizednet.bris.ac.uk/virtual/economy/library/economists/keynesth.htm
Mullins, Eustance Clarence. Secrets of the Federal Reserve. Bankers Research Inst., Washington: 1991.
Grieder, William. Secrets of the Temple: How the Federal Reserve Runs the Country. Touchstone Books, San Fransisco: 1989.