Introduction
The U.S. central banking system, known as the Fed, is responsible for monetary policy and regulation. The Federal Reserve Act was enacted in 1913 to establish the Federal Reserve, which functions as the central Bank of the United States. The Federal Reserve has several responsibilities, including maintaining a stable monetary and financial system, conducting monetary policy, regulating and overseeing banks, promoting financial stability, and providing financial services to the U.S. government.
The United States government utilizes the Federal Reserve as a financial intermediary, which provides various financial services such as handling government transactions, including payments. This paper is dedicated to looking deeper into its role, what tools it uses to facilitate its activities, and the effectiveness of these tools and actions regarding the Great Recession.
Tools Used by the Fed
To attain its economic objectives, the Federal Reserve employs multiple policy instruments. These include discount rates, open market operations, forward guidance, qualitative easing, and reserve requirements.
Engaging in Open Market Operations
One of the functions of the Federal Reserve is to engage in Open Market Operations, which involves the purchase and sale of U.S. government securities, such as Treasury bonds and bills. (Walter & Wansleben, 2020). The act of the Federal Reserve purchasing securities has the effect of augmenting the money supply and infusing additional funds into the economy. Injecting cash into the economy lowers interest rates, encourages lending and borrowing, and, most importantly, stimulates economic activity. Conversely, when the Fed sells securities, it reduces the supply of money supply this has the effect of increasing interest rates and can result in a decline in economic growth.
Utilizing the Discount Rate for Direct Lending
Another function is the discount rate through direct lending to banks and other financial institutions. When banks borrow money from the Federal Reserve, the interest rate that they are charged is known as the discount rate. By changing the discount rate, the Fed can encourage or discourage banks from borrowing money and lending it to consumers and businesses. Banks can borrow money at a lower cost when the discount rate is low, encouraging lending and stimulating economic activity. Conversely, when the discount rate is high, banks may be less likely to borrow money, which can reduce lending, thus slowing down economic activity.
Setting Reserve Requirements for Banks
Third is the Reserve requirements; this is the number of money banks need to hold in reserve, either in cash or deposit at the Federal Reserve. They are typically used only during extreme economic stress, such as the financial crisis in 2008, and thus less frequently used. The Federal Reserve can impact the lending capacity of banks by adjusting the reserve requirements. Banks can lend more money when the reserve requirements are low, stimulating economic activity. On the other hand, higher reserve requirements lead to lower lending rates and, eventually, lower economic activity.
Employing Forward Guidance for Policy Decisions
The fourth tool is the forward tool, a communication tool the Fed uses to guide its future policy decisions. This tool is handy when the interest rates are low and the Fed needs more room to maneuver with other policy tools (Lunsford, 2020). The Fed can influence market expectations and shape economic behavior by communicating its expectations for future interests, inflation rates, and economic growth. Lastly is Qualitative Easing. The process entails the acquisition of substantial quantities of government securities, which may include mortgage-backed securities or treasury bonds, by the Federal Reserve. This cash injection can decrease long-term rates of interest rates and arouse economic action. Qualitative easing is used during times of economic crisis, such as the Great Recession, when other policy tools may be less effective.
Assessing the Effectiveness of Federal Reserve Tools
The effectiveness of Federal Reserve tools is reliant on various factors, such as the present economic state, the interest level, and the behavior of consumers and businesses. Generally, the Fed’s policy tools have effectively achieved the set goals, with Open market operations being the most effective tool. It is the most frequently used tool in economic downturns and upturns.
Regarding how often the tools are used, the Fed’s decisions are made on a meeting-by-meeting basis by the Federal Open Market Committee (FOMC), which is done approximately eight times a year to determine the economic state and which tool to use.
Overall, the Federal Reserve, as seen above, has a range of policy tools that it can use to achieve its economic goals; the specific tools used by the feds will depend on the state of the economy and the Fed’s assessment of which policies are most appropriate to achieve its objectives. The efficiency and frequency of use depend on the state’s economic status.
The Great Recession
The Great Recession was a severe economic downturn that commenced in 2008 and lasted for years. Several factors, such as a housing bubble, a subprime mortgage, and a financial crisis, triggered the Great Recession. All these factors lead to a sharp decline in the state’s economic status, a high unemployment rate, a decline in housing prices, and a credit crunch. Following the occurrence of the Great Recession, central banks and governments took various measures to stabilize the economy and prevent further damage.
The Actions Taken by the Fed to Mitigate the Impact of the Great Recession
Lowering Interest Rates
The Federal Reserve took several actions, the key ones being lowering interest rates. The Fed lowered its benchmark interest rate, the federal funds rate, to almost zero in December 2008. This helped to lower borrowing costs for businesses and households, stimulating economic activity.
Implementing Mulit-Rounded Quantitative Easing
Secondly, the Feds implemented several rounds of quantitative easing, which involved purchasing large quantities of treasury and mortgage-backed securities to surge the supply of money and reduce long-term rates of interest (Reisenbichler, 2020).
Performing Lending Activities
Third, several lending activities by the Feds were established to provide liquidity to financial institutions experiencing funding difficulties, such as the Term Auction Facility and the Primary Dealer Credit Facility.
Establishing Currency Swap Lines with Foreign Central Banks
Additionally, the Fed established lines for swapping currency with various foreign central banks, such as the European Central Bank. These swap lines helped provide U.S. dollars to foreign banks experiencing funding difficulties. The Fed also guided the public and financial markets about the likely path of future interest rates, thus helping to anchor market expectations and support the economic recovery.
Regulating and Supervising Financial Systems
Lastly, the Feds took regulatory and supervisory actions to strengthen financial systems and prevent future crises. These actions, at the time, were the best actions the Feds could have taken to mitigate the economic disaster.
Lessons from the Great Recession for Addressing the COVID-19 Economic Crisis
The Great Recession offered several lessons for the Federal Reserve and policymakers in responding to the current COVID-19 economic crisis. First, swift and decisive action by the fed plays a vital role in mitigating an economic crisis (Jorgensen, 2021). The Fed acted swiftly during the COVID-19 crisis by cutting interest rates near zero and implementing various lending and liquidity facilities.
Secondly, fiscal and monetary policy coordination is essential. During the COVID-19 crisis, the Fed worked closely with the treasury department to support the economy through fiscal stimulus measures. Lastly, the Great Recession showed that equity and inclusivity should be prioritized to prevent the unequal impact of economic crises on different segments of society.
Conclusion
It is evident that the Federal Reserve plays a crucial role in maintaining economic stability not only in the United States but also in other nations. It uses various tools highlighted above according to its efficiency in handling an inevitable economic crisis. Federal Reserve is also an essential body in dealing with the economic crisis brought about by COVID-19, hence an essential part of the problem-solving arena.
References
Jorgensen, A. (2021). The Treasury market in spring 2020 and the response of the federal reserve. Journal of Monetary Economics, 124, 19-47. Web.
Lunsford, K. (2020). Policy language and information effects in the early days of Federal Reserve forward guidance. American Economic Review, 110(9), 2899–2934. Web.
Reisenbichler, A. (2020). The politics of quantitative easing and housing stimulus by the Federal Reserve and European Central Bank, 2008-2018. West European Politics, 43(2), 464-484. Web.
Walter, T & Wansleben, L. (2020). How central bankers learned to love financialization: The Fed, the Bank, and the enlisting of unfettered markets in monetary policy. Socio-Economic Review, 18(3), 25-653. Web.