A report on the monetary policy of the Fed during the economic crisis between 2007 and 2009

A report on the monetary policy of the Fed during the economic crisis between 2007 and 2009

Introduction

Monetary policy is a process by which the central bank of a country controls the money supply in that country. The fundamental goals of the monetary policy are to stabilize prices and reduce unemployment rates among others. The monetary authority often uses tools of monetary policy to adjust the supply of money in a country. These tools mainly target the interest rate in pursuit of promoting economic growth and stability in the country. Depending on the situation on the ground, the monetary policy applied can be expansionary or contractionary. Expansionary policies aim at reducing unemployment rates by increasing money in circulation whereas contractionary policies aim at lowering inflation rate by reducing money in circulation. The Fed refers to the central bank of the United States (U.S), and is the body that controls monetary policy in the U.S. This is mainly done by the Federal Open Market Committee (FMOC).During the summer of 2007 financial crisis came up in the U.S. The reasons that led to the crisis are traceable as pointed out by Brunnermeir (77). According to Gourinchas (27) there was excess demand for safe debt instruments which made the financial sector to come up with pseudo triple-A assets which are vulnerable to financial crisis. Crisis in 2007-09 “reflected panic in wholesale funding markets that left banks unable to roll over short-term debt” (Wheeler 89). Once the crisis hit, it also became rapidly obvious that the policy interest rate was not a sufficiently powerful instrument to offset the contraction in aggregate demand and stabilize output. With federal funds rate rapidly approaching the zero nominal bound, traditional monetary policy had to be supplemented by vigorous fiscal policy as well as non-conventional monetary policy. Aggressive reaction to financial crises should be taken by the central banks (Wheelock 89). President Obama nominated Ben Bernanke for the second term as the chairman of the Board of Governors of the Fed to assist in preventing the economic crises.

Open market operation

This is a monetary policy tool that uses government securities to solve the problems money supply in an economy. The Fed buys or sells U.S treasury securities in the secondary market which ensures a desired level of bank reserves has been produced. Buying of securities from the public serves as an expansionary monetary policy as it increases the amount of money in the banks. This increases the amount of money in circulation. Selling treasury securities on the other hand decreases the amount of money in circulation since people will now hold their wealth in terms of securities and not cash balances.

The Fed increased the level of temporary open market operations on 9^th August 2007. This helped in increasing money in circulation which stimulated economic activities (tobias and Hyun 1). The Fed further announced its intention to repurchase of securities ‘repos’ in 28 days cumulating to $100 billion (Thornton 16). It also created Term Securities Lending Facility (TSLF) with an intention to lend $200 billion worth of treasury securities to primary dealers.

Reserve requirement

This implies the fraction of demand deposit accounts and fixed deposits that must be held as reserves at the Federal Reserve Banks. They are non-interest bearing reserves. An increase in reserve requirements discourages borrowing by banks hence individuals thereby restraining economic activities. A decrease in reserve requirements ratio encourages borrowing by the banks. This avails enough cash to banks for lending to individuals which in turn stimulates economic activities.

The Fed decided to reduce the reserve ratio to encourage borrowing.

Discount rate

This is the interest rate at which the Fed lends money to the financial institutions as their lender of last resort.These are secured short term loans which aim at providing money to the depository institutions which require them. Increasing the discount rate will discourage borrowing from the Fed..............