Federal Reserve Operations in the United States Essay

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Federal Reserve Operations in the United States

Functions of the Federal System in Control of Money Supply

The discount rate, according to the federal system, is the interest rate, which the Federal Reserve imposes on the loans it gives to Federal Banks that are troubled and need financial support. Processing of lending to the banks is done through the 'discount window', which in most cases is controlled by the Reserve Banks.

Factors influencing Federal Reserve to adjust discount rates

Discount rates provided by the Federal Reserve to the borrowing banks is in most cases used as tools in controlling the amount of money supply in the country's economy (Wiedemer & Baker, 2012). Currently, the Federal Reserve (Fed), uses the discount rate strategy widely and frequently, because of the nature of the tool, which is simple to implement and convenient for the public. In most cases, two factors will lead to the adjustment of the discount rates by Fed. One is when there is excessive money supply and the other when supply of money in the economy is limited.

When Fed decides to increase the discount rates, it notifies all the banks it lens to that there is an increase in the discount rates, and the increase directly affects the public who borrow money from the banks. The public is affected in that they have to pay enormous interests when they borrow money. This discourages them from borrowing money from banks, hence reducing any excess money supply in the economy. The contrary happens in case of reduction of discount rates by Fed. When rates are reduced, the reduction leads to rapid lowering of interest levied to borrowers by banks. Reduction is adopted in case the Federal Reserve wishes to increase the money supply in the economy (Wiedemer & Baker, 2012). The discount rates of Fed will influence the interest rates of eligible banks.

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The relationship is straightforward, an increase in discount rates by Fed will lead to increase in interest rates by banks and a reduction in the discount rate will reduce the interest rate of banks, which results to increase in money supply in the economy (Delaney & Whittington, 2012).

Aim of Monetary Policy in effecting Disinflation

Disinflation could be defined as the rapid reduction of the inflationary rates, and should be differentiated from deflation, which is just the reduction in commodity prices in the economic markets. For disinflation to occur there has to be a sacrifice, because Federal Reserve implements a contractionary monetary policy. Fed will be obligated to reduce the money supply rates, perhaps using the discount rates approach, and this would lead to contraction of aggregate demand. Reduced aggregate demand will cause firms to produce lesser goods and services (lesser quantities). Any fall in the production levels will lead to higher unemployment rates. Therefore, at a certain point, the inflation rates will be low, but there is high unemployment rate. In the end, the public realizes the low rate in an increase of prices, and inflation levels fall. Eventually the rates of unemployment get back to their initial position, but disinflation is realized. Evidently, (as indicated in the Philip's curve) any state with intentions to avoid inflation has to endure long-term effects of unemployment and reduced production by firms (Mankiw, 2011).

Monetary Policy and its effects on Money Supply

The Fed, which is mandated to control monetary policy, makes changes to the policies so that they control the money supply in the economy. Mostly, this is done through operations of the open market. The Federal Reserve System transacts through the purchase and selling of treasury bonds, hence adjusting the money supply through banks reserves. Due to its transactions with government bond markets, effects of initial liquidity impact will….....

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