Fed Management Through Commercial Banks | Free Essay Example

Fed Management Through Commercial Banks

Words: 913
Topic: Business & Economics

Monetary actions refer to the steps that are taken by the Fed to ensure stability in the economy and the achievement of other macroeconomic objectives. The actions range from open market operations to bank rates and reserve requirements for a commercial bank. The Fed needs to administer its objective through the commercial banks, and as such, the actions should focus on ensuring and promoting economic growth. The current monetary action is to regulate reserve requirements.

The rationale for taking the action is based on the economic outlook of the United States indicates that private sector investment in technology is on a decline with tourism increasing during the summer. Therefore, the GDP of the country is reflecting an improvement in the various sectors of the economy. Fed responds to the situation prevailing in the economy through monetary actions that respond to the circumstances. The increase in the currency-deposit ratio implies that money is being withdrawn from the banking system reducing the amount of money available to banks to lend out. The populace view bank deposits in sub crisis to be risky. This is because banks are likely to fall during such a crisis. Therefore, money creation by banks through money multiplier is limited, hence a fall in the money supply (Mishkin, 2010).

An increase in the reserve-deposit ratio is negatively related to money multiplier and money supply. The reason is that it will lead to a reduction of money available to banks to lend. The banks in times of sub crisis view money lending as a risky adventure. This is because a considerable number of borrowers are likely to default their debt. During such times, banks prefer holding a high reserve-deposit ratio since they believe it is much safer. The main effect of the two changes will be on the monetary base (MB), this is because of MB= Currency (Money held by the households) plus Reserves (money held by banks). The increase in currency-deposit and the reserve-deposit ratio will mean a decline in the monetary base. The money supply is given, thus, by monetary base multiplied with the money multiplier.

The sub-prime crisis will lead to a reduction in the money supply in the economy. Therefore, a reduction in the money supply will result in a decline in output and a rise in interest rate. The economy through the Fed changes the amount of money in circulation in the economy. When the amount of money supply is shifted, the economy’s equilibrium interest is changed. In this case, a contraction in the money supply will create a left shift of the LM curve, hence a rise in the interest rate. The effect of the increase in interest rate is witnessed by the declining investment rates by the private sector. The result of a sub-prime crisis is the declining rate of capital formation. The private investors look at bank loans as risky and expensive, therefore, as a result, they cannot borrow a huge sum of money due to high interest.

The economy’s Gross Domestic Product will decline due to declining investment and low pace of government spending. The fed is controlling the amount of money available for banks to lend out. The economy will have minimal net export that results in reduced output. The economy faces the problem of the low money supply during a sub-prime crisis. The problem of the low money supply is associated with a low growth rate due to reduced investment because of high-interest rates. The impact of high inflation is also experienced during such a situation. The effects of a crisis can be solved by putting in place a monetary policy (Mishkin, 2010).

The effect of reduced money supply can be tackled by the monetary policy. Tools of monetary policy such as open market operations, reduced discount rates, and reduced reserve requirements will lower the rate of interest of the economy. The government through open market operations will sell securities such as treasury bonds and bills to the populace. This implies that the money held by the public can be reduced. As a result, banks will have money to advance to banks at a lower rate so that investment options can be taken. As a result, a high investment rate will boost economic growth.

The expansionary monetary policy has a positive effect on the challenges that an economy is going through in a sub-prime crisis. The challenges include a low growth rate and skyrocketing interest rates. The policy will reduce the interest rate which a recipe for increased capital investment, hence an improvement in economic growth. The use of discretionary monetary policy is suitable for the reserve bank in control of the prevailing economic crisis. The result of a sub-prime crisis is ballooning inflation rates; the households find it difficult to meet their daily needs. To reduce the high inflation rates, which are closely related to the deficiencies within the financial sector, is to adopt monetary policies that are geared towards reducing the interest rates and stability of commodity prices (U.S. Bureau of Economic Analysis, 2012).

The monetary actions have accomplished the intended effect with; the unemployment rate declining from the rate of 9% in 2010 to 8.3% in the year 2012, due to an increase in job opportunities. Interest rates falling as evident by the increase in borrowing by the private investors; as well as, an indication of improvement in the growth of GDP as evidence that in 2011, the growth rate was 3.7% then improved to 4.7% in 2012.


Mishkin, F. S. (2010). The economics of money, banking & financial markets (9. ed. (and the 2. ed. of the business ed.). Boston: Addison-Wesley.

U.S. Bureau of Economic Analysis (BEA). (n.d.). U.S. Bureau of Economic Analysis (BEA). Web.