The Federal Reserve System is the U.S. central bank, which conducts the nation’s monetary policy, supervises the banking system, and maintains the stability of the financial system. It uses a wide range of instruments to perform its functions. These instruments include the discount rate, the reserve requirements, and the open market operations. The Federal Reserve System has a significant impact on the country, because it can affect many aspects of the U.S. economy, including money supply, unemployment rate, foreign exchange rates, prices of goods and services, and the entire investment climate of the country.
The Federal Reserve System can conduct either expansionary or contractionary monetary policy. The former increases money supply and stimulates the economy, whereas the latter decreases money supply, and is usually used to reduce the inflation rate. The FED can regulate the money supply using all instruments. When it reduces discount rates and reserve requirements, it increases the money supply, and puts more money into the banking system. The money supply line (MS1) moves left to MS2, and the short-term interest rate declines. When the FED increases discount rate and reserve requirements, the supply of money shrinks.
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If the interest rates in the USA are relatively higher then in the rest of the world, foreigners will want to invest into the U.S. economy. They will increase the supply of the foreign currency, and increase their demand for U.S. dollars. The quantity of dollars will move from $1 to $2. In addition, the foreign currency price per dollar will increase from C1 to C2. Consequently, the dollar will appreciate in value relative to the foreign currency.
Furthermore, interest rates have a great impact on the investment climate. If the interest rates decrease from r1 to r2, the economy will become more attractive for investors, and the investments will increase from I1 to I2.
The increase in both investments and money supply has many positive consequences on the economy. It prompts consumers, businesses, and government to borrow more money. This money will be spent on goods and services. Consequently, these factors increase the aggregate demand (AD1), and moves it left to AD2. As the aggregate supply curve (AS) is steady, increase in aggregate demand will stimulate the GDP growth, and the total output Q1 will move to Q2.
An increase in the nation’s GDP usually results in creating new jobs. Consequently, this will reduce unemployment. However, an increase in aggregate demand will also result in higher inflation rate. The price level will increase, creating some problems for the economy. The Federal Reserve System can use contractionary monetary policy to fight inflation. Such policy involves higher interest rates and higher reserve requirements. In addition, the FED may sell securities to decrease the money supply, and thus to avoid inflation. Consumers, businesses, and government will borrow less money due to a high interest rate. As a result, these actions will decrease the inflation rate.
However, sometimes the policy of the FED can be inefficient. One of the examples is a so called “liquidity trap”, a situation when money injections, as well as an increase in money supply, fails to stimulate the economic growth. This situation was described in Keynesian economics, and it seems that the U.S. economy suffers from it. Though the interest rates are very low, the unemployment rate is still relatively high. Furthermore, the GDP growth is approximately 2%, which is not enough for proper recovery from the recent financial crisis. All phases of the quantitative easing, conducted in the USA, failed to give real results, because the uncertainty about the future of the U.S. economy is still very high.