You are on page 1of 11

[TYPE THE COMPANY NAME]

[Type the document


title]
[Type the document subtitle]
goyalankit85
[Pick the date]

[Type the abstract of the document here. The abstract is typically a short
summary of the contents of the document. Type the abstract of the document
here. The abstract is typically a short summary of the contents of the document.]

Introduction:
The world of finance is very dynamic as well as complex by nature. It impacts every
other business organization in various economic activities. Any company, be it belonging to
manufacturing, insurance, retail or energy sector, deals with financial transactions, takes bank
loan to buy machineries, buys material from suppliers who also take credit based loans, sells
products to consumers who pay income tax to the government, etc. In this way, almost all the
industries are related to finance industry in direct or indirect manner. The financial markets of
United States are one of the largest and most liquid markets of the world. In 2012, the finance
industry contributed almost 7.9% in the gross domestic product (GDP). This percentage was
even more before the financial meltdown seen in 2008. the interventions from federal reserve,
specifically changes in the fiscal and monetary policy brought the economy back with the growth
rate of 3-4% in recent years. It further brings out interest to understand the various caveats of
monetary policy and how it is devised considering various environmental factors, which is
certainly a tedious task. This report discusses about monetary policy, how it is devised, different
tools used by Federal Reserve as part of its monetary policy, how the concept of centralized
banking system and monetary policy evolved etc. The report further discusses about the changes
in monetary policy that brought up USA from subprime crises and a reflection over the recent
monetary policy published by central bank in past few years.
What is monetary policy?
It is the process by which monetary authority or central bank of a country (Federal
reserve in case of USA) aims to achieve macroeconomic objectives by controlling the supply of
money, interest rates and many other economic parameters. the major objectives of the monetary

policy are sustained economic growth rate, price stability, maximum employment, financial
market stability etc. In United States, the Congress has devised a policy to keep the monetary
policy free from political influence. Monetary policy differs from fiscal policy in the sense that
fiscal policy focuses on how government make expenditures and revenue collection on yearly
basis but monetary policy focuses on how economic growth rate is sustained by controlling the
money supply and interest rates.
The major tools of monetary policy are open market operations, reserve requirements,
interest and discount rates, currency peg, discount window etc. As part of open market
operations, Federal reserve sells and buys US government bonds and pulls or push money in the
market ( as government banks involve in these transactions). Secondly, by increasing the reserve
requirements the banks need to keep more money with them and thus lending decreases which
reduces the money floated in the financial markets. Third, by decreasing the discount rates bank
tend to borrow more money (at cheaper rate) from Federal reserve to maintain their reserve
requirements. So, banks are induced to keep lower excess reserves with them and they tend to
ease lending interest rates to public entities.
http://www.diffen.com/difference/Fiscal_Policy_vs_Monetary_Policy
http://www.federalreserve.gov/faqs/money_12855.htm
http://economictimes.indiatimes.com/definition/monetary-policy
https://www.federalreserveeducation.org/about-the-fed/structure-and-functions/monetary-policy/
http://www.frbsf.org/education/teacher-resources/what-is-the-fed/monetary-policy
Formation of Centralized Banking system:

The prelude of central banking system was first devised in 1791 when senate approved
the bank bill drafted by Alexander Hamilton. In response, Hamilton mentioned that "There is
scarcely any point in the economy of national affairs of greater moment than the uniform
preservation of the intrinsic value of the money unit." During 1775 to 1790 every state was
printing his own notes to finance the American Revolution. The first paper money published in
the nation was termed as "continentals". At the end of revolutionary war, there was substantial
debt on the government (due to large amount of printed notes by each state) and the inflationary
pressure they had brought on the economy.
The first bank of United states was established in 1791 and it existed till 1811. It was
modeled by Alexander Hamilton himself, as a treasury secretary of George Washington led US
government. The bank started with a capital of $10 million for which many private companies
and investors had contributed. The main office was in Philadelphia. It took care of the
government debt but the commercial banking practice was still not approved by Senate (by 1
vote) as the US Constitution had granted the power of taxing and printing money to Congress
and not to any private institute. The second bank was established in 1816 (and remained till
1836) as the federal debt due to 1812 war again started accumulating. The state chartered banks
were defaulting, public opinion for central bank was becoming favorable and the federal
government also wanted to resolve the debt problem. Thus, second bank was established with
$35 million initial capital. Over the period, second bank also failed and then national banks were
established from 1863 to 1913. The civil war in 1873, 1893 and 1907 made the depositors
cautious and they started pulling out their money from the bank which converted a solvent bank
into an insolvent one.

Finally, in 1913 Federal Bank was established which acted as Bankers bank and public
operations were separated from it. The commercial lending from Federal bank was closed, profits
in excess of cost were handed over to US treasury, authority to US payment system was given to
Fed. The open market operations were first conducted by New York Fed President Benjamin
Strong in 1920. Gradually, in 1933 the gold standard was demolished and the concept of
monetary policy with a foundation of flat money was devised. In 1935, the Federal Open Market
Committee (FOMC) was established by Congress to monitor the federal bank operations, which
is still being followed.
https://www.minneapolisfed.org/community_education/student/centralbankhistory/bank.cfm
History of US Monetary Policy
During the first world war the government debt had increased to a level of $1 billion
consisting of long term securities. At that moment the only monetary policy tool was discount
window to offset the reserve against the gold inflows. The governors did not like to change the
discount rate too frequently in this era. When the war started, the United States gave excessive
debt to the allies and the need of gold deposit was eliminated. Treasury department also issued
some certificates (Treasury Liberty Loan certificates) which were short term by nature at a rate
well below the market rate to lure the investors. In 1920s the discount window was largely used
by the banks to take debt from Federal Reserve. The large banks were supposed to close the debt
in 1 week and smaller banks for a couple of weeks. The discount rates were usually kept
modestly above the rate on ninety-day bankers acceptances and modestly below the rate on four
to-six-month commercial paper. These discount rates were being changed almost two times in a
year. Adolph Miller introduced a real bill doctrine by which credit used to fund commercial

activities were expanded. Hence, financing through commercial bills was motivated over
speculation on discount window. In this period the purchase and selling of Banker's Acceptance
(BA's) was promoted as well. In 1930, the purchase and sell of Treasury securities was found to
be the most common market operation held by Federal Reserve. When Federal Reserve found
interested to buy more BAs than what OMIC wanted then offering rate was adjusted.
Federal reserve's monetary policy had reflections of a major contraction from 1929 to
1933. In 1929 Fed was unable to provide stimulus to the markets and the country's economy
gradually crashed out. On October 29, 1929, when the stock market crashed, the New York Fed
bought about $125 million of Treasury securities, five times the maximum weekly purchase
amount authorized by the OMIC. In 1930, the OMIC was replaced by the Open Market Policy
Conference (OMPC). The discount rates were decreased by the Federal Reserve until 1931 in
various steps to put more money in the market but the pace was not up to the mark to get rid of
great depression quickly. It also raised the rates in October 1931 to stop the gold outflows when
Great Britain had went off the gold standard. In 1933 Federal Reserve was allowed to float
Federal Reserve notes against government collateral and emergency issuance against other
collateral. The Board was given power to alter member bank reserve requirements within a fairly
wide range that included the existing ratios as lower bounds.
The gold and currency flows did stimulate money growth during 1933 to 1937, but
reserves grew even faster and the banks built up unprecedented holdings of excess reserves. In
1937 FOMC started making open market purchases to push money in the open markets. Between
April 4th to April 28th, almost 96 million dollars of treasury securities were bought. The
discount rates were further cut to 1.5% and then to 1 %. After the second world war the Federal
Reserve actively starting purchasing the Treasury debt. It also tried to keep its borrowing costs

low and hence encouraged held all the interest rates at same level. After the war the inflationary
pressure had again started to loom up and then Federal Reserve increased the interest rates to sip
out money from the markets.
In 1950s Federal Reserve receive the accord to make independent monetary policy with
least intervention from Treasury and government. The "Trading Desk" increased the number of
dealers who could participate in open market operations and thus number of market players for
Federal Reserve increased. FOMC also removed interest rate targets to ensure flexibility and
economic growth. The banks were guided to keep higher level of "free reserves". After the
introduction of matched sale-purchase transactions (MSPs) in 1966, the Trading Desk was also
able to drain reserves temporarily. The funds rate used to be constant as banks kept adequate
reserves and most of the trading operations held near the discount rate. During 1970s Federal
Reserve attempted to keep constant federal funds rate and targeted money growth. Inflation in
the United States encouraged outflows of official gold holdings and made the Bretton Woods
system of pegged exchange rates progressively less viable.
In 1970, the Federal Reserve formally adopted monetary targets with the intention of
using them to reduce inflation gradually over time. In 1980s The FOMC targeted the borrowed
reserve level directly, instead of computing total and non-borrowed reserve levels linked to a
money measure and deriving a level of borrowing that moved with the deviations of that
aggregate from target. In this way Federal Reserve dynamically changed its monetary policy to
keep the economic growth upbeat.
https://research.stlouisfed.org/aggreg/meulendyke.pdf

How monetary policy was changed in subprime crisis

During the time of subprime crisis in US there was changed made in


monetary policy. Interest rates if increased by the government results in
expensive lending to private companies companies but it helps in easing the
inflation. But monetary policy changes made during subprime crisis were
reverse to this and interest rates were brought down even near to zero so as
to triple the monetary base of the country (Daly et al, 2014). Further this
reduced the value of dollar and in year 2012 US dollar was valued 95% lower
as compared to its value in year 1913. Reduction in fund rate in % terms can
be given by figure 1 below which clearly indicates that fund rate reduced
drastically from year 2007 to 2009 and remained near to zero in year 2009.

Figure 1: Showing the trend of Fed funds rate in % from year 2006 to 2009
Source: Federal Reserves
Fed has taken strong action by continuously lowering down the interest rate
with cut in 0.5% to 0.25% steps. Despite of these efforts from Federal
government, results were not desirable and due to which continuous rate
decline was continued by Fed. The major reason which can be given in
support of the Fed was just to relax the pressured felt by the US system.
Despite of the fact that policy makers felt that such lowering rate of interest
would only lead to cyclical slow down in economy there was no major action

taken to stop these activities. Critic of the Fed action can be given by the fact
that Fed took so long till 2007 for lowering down interest rates,
misunderstanding the priority as curbing inflation instead of growth and
ineffective intervention with 25 basis point changes.
Examples of recent monetary policy changes by the Fed and how it
has impacted the markets and economy
There have been recent changes in the monetary policy made by Fed so that
economic and market factors can be controlled in the country. Changes in
the monetary policy made by Fed in recent time are not oriented towards the
reduction of inflation but to attain growth through critical steps. Federal
government took the decision to increase their bond holding and bank
reserves up to $1 trillion in FY 13, limiting it to $500 million in FY 14 and
making it 0 till FY 15. These attempts would help the private sector
organizations to become the pro-growth mirror-image change in mix of its
lending (John, 2010). Another important decision take by Fed recently was
not to replace the long term liabilities of the bank with long term high quality
debt for Fed. Instead of long term debt for the lenders it was advisable to
provide the short term loan for the small business organizations so that
these business organizations can be helped through short term loans
provided to them. The main impact of reduction in bond buying for Fed was
increase in liquidity amount as banks maintained highest liquidity position of
$3 trillion in year 2014. This helped banks maintained high liquidity and
investor confidence was re-gained by the banks by maintaining suitable
liquidity with them (Hassett, 2012). This would allow commercial banks to
get higher amount of deposits and to provide higher amount of loans to the
consumers. In present age Fed government stopped regulating the banks
through their liquidity position and direct regulations were imposed on the
banks (Davies, 2012). It was expected that near zero interest rates would
stimulate the consumers but these level of financial situations were suitable
for the financial emergencies only.

Conclusion:
It can be concluded the monetary policy is one of the most important policies
formulated by Federal Reserve bank. The major tools of monetary policy are
open market operations, reserve requirements, bank fund rate and discount
rate. The central bank uses these tools after understanding the various
macroeconomic parameters and then tries to tune them up to achieve
maximum economic growth rate. The present state of Federal Reserve was
identified and founded after series of banking models formulated since 1791
and later. The role of Federal Reserve has been phenomenal in managing the
high level of government debt post first and second world war. It has also
established many committees (like FMOC and Trading Desk) for dedicatedly
controlling the open market operations. The monetary policy changes made
during subprime crisis were mostly oriented towards reduction in interest
rates down even near to zero so as to triple the monetary base of the
country. Changes in the monetary policy made by Fed in recent time are not
oriented towards the reduction of inflation but to attain growth through
critical steps. Thus, Federal Reserve has been consistently monitoring the
macro economy and change its monitory policy to ensure growth and
prosperity for the market participants as well as whole country.

References
Hassett, K. (2012). How the Fed Works. The American Enterprise Institute for
Public Policy Research. Retrieved 2014-12-07.
Davies, P. (2012). Right on Target. Retrieved 2014-12-07. Federal Reserve
Bank of Minneapolis
John T. (2010). Monetary Policy and the Long Boom, Federal Reserve Bank of
St. Louis Review, NovemberDecember 2010.
Daly, Herman E; Farley, Joshua (2014). Ecological Economics: Principles and
Applications. Island Press. p. 250. ISBN 1-55963-312-3.