Federal Reserve Paper Essay

The purpose of this paper is to evaluate the Federal Reserves’ discount rate, monetary policy, and stimulus program through the money multiplier. What are the factors that would influence the Federal Reserve in adjusting the discount rate? According to Chron if prices rise too fast or the economy starts slowing down, the Federal Reserve uses the discount rate as a way of manipulating interest rates to stabilize the economy. This change can either increase or decrease how much you’ll pay to borrow money. How does the discount rate affect the decisions of banks in setting their specific interest rates? According to Chron although changes in the discount rate affect your interest rate, the Federal Reserve does not lend directly to business owners. Rather, the Federal Reserve lends money to depository institutions such as commercial banks. Depository institutions must pay interest on the money they borrow from the Federal Reserve. The discount rate is the interest rate the Federal Reserve charges its depository institution borrowers. Loan interest rates fluctuate in response as depository institutions pass the discount rate changes along to you. How does monetary policy aim to avoid inflation? According to Tutor2u monetary policies tend to invest in various assets, in order to avoid the losses caused by inflation. Increase in interest rates is also another measure, in order to contract the real money supply. Monetary policy controls money supply by increasing the discount rate, and also through increasing and decreasing the reserve requirements of lending banks. If the reserve requirements decrease, the banks can lend more money to consumers and businesses. If the reserve requirements increase, banks have to keep more money in with the fed. The interest rates increase, and people have an incentive to save and earn interest from the bank. If the interest rates decrease, then people do not have an incentive to save and they spend their money. How does a stimulus program (through the money multiplier) affect the money supply? According to Forbes a study by Obama administration economists Christina Romer and Jared Bernstein predicts that the stimulus plan being debated in Congress will raise the gross domestic product by $1. Such a multiplier effect has been heavily criticized by a number of top economists, including John Taylor of Stanford, Gary Becker and Eugene Fama of the University of Chicago and Greg Mankiw and Robert Barro of Harvard. The gist of their argument is that the government cannot expand the economy through deficit spending because it has to borrow the funds in the first place, thus displacing other economic activities. In the end, the government has simply moved around economic activity without increasing it in the aggregate. The problem is that fiscal stimulus needs to be injected right now to counter the liquidity trap. If that were the case, I think we might well get a very high multiplier effect this year. But if much of the stimulus doesn’t come online until next year, when we are likely to be past the worst of the slowdown, then crowding out will greatly diminish the effectiveness of the stimulus, just as the critics argue. The theory of the money multiplier states that for every $1 spent by the government, it drums up $1. 50 in the economy. So, if the government spends more money via a stimulus package, the economy should expand by 50% of the amount of the stimulus package. In conclusion the following topics have been discussed and described to give one an idea of its functions: What is the factor that would influence the Federal Reserve in adjusting the discount rate? – How does the discount rate affect the decisions of banks in setting their specific interest rates? – How does monetary policy aim to avoid inflation? -How does a stimulus program (through the money multiplier) affect the money supply?