Fed Vs Recession Essay, Research Paper

The economy of the United States of America is the largest in the world. In 2000, the U.S. had a Gross Domestic Product (GDP) of 9,318.5 billion dollars. (Real Gross Domestic Product, 2001) The United States has an economy that is market driven but government regulated. Because the economy is market driven, it tends to have a cyclical nature. The market contracts, which causes a decrease in GDP, and it expands which causes the GDP to rise. This cycle is constantly in motion.

Before the Great Depression, the government did not intervene with the economy. It did nothing to boost the economy during a slump or slow it down if it grew too fast. The economic thinkers of the time believed that the economy would self-adjust if anything was to happen. Once the economy began its downward spiral in 1929, it did not self-adjust itself. It was during this time, that Lord Keynes suggested that government intervene. This became the basis for modern day economics.

Today, the government plays on active in the economy. Its primary goal is to act as a moderator for when it grows and slows down. It also acts to promote economic growth while keeping inflation low. One of the major factors that

helps to achieve this balance is the Federal Reserve System.

Congress created the Federal Reserve System in 1913 to act as the central bank of the United States. (Board of Governors, 2001) The Federal Reserve System has four primary duties. These are to conduct the nation s monetary policy, supervise and regulate banking institutions while protecting the credit rights of consumers, maintaining the stability of the financial system, and to provide financial services to the U.S. government, the public, financial institutions, and foreign official institutions. (Board of Directors, 2001) The Fed also maintains price stability and economic stability. (Koudsi, 2001, p. 30)

The Federal Reserve is comprised of 12 districts. There are 12 branches and twenty-four branches. The Board of Governors is made up of 7 members. The president chooses them to serve fourteen-year terms. However, the Senate must confirm these appointments. The president also designates the Chairman of the Board and the Vice-Chairman. The Senate also approves these positions. The officers are appointed for four-year terms. (Structure of the Federal Reserve, 2001) The Board of Governors is in charge of setting the discount rate.

The Federal Open Market Committee establishes policies in order to foster the long term goals of price stability and sustainable economic growth . (Federal Open Market, 2001) The FOMC is in charge of setting the target Federal Funds rate. The Federal Open Market Committee is comprised of the seven members of the Board of Governors plus the President of the Federal Reserve Bank of New York and four other seats which are held by the other Presidents of the other Federal Reserve Banks. These four seats are rotated among the Presidents of the other Federal Reserve Banks and they are held these positions for one year. The FOMC elects its own chairman and vice-chairman at the beginning of each year. Traditionally, the Chairman of the Board of Governors is elected Chairman and the President of the Federal Reserve Bank of New York is elected Vice President. (The Federal Open Market Committee, 2001)

The FOMC is considered the most important monetary policymaking body of the Federal Reserve System. It is responsible for creating policies. These policies are designed to promote economic growth, full employment, stable prices, and sustain a pattern of international trade. It makes key decisions regarding the conduct of open market operations purchases and sales of U.S.

government and federal agency securities which affect the provision of reserves to depository institutions and, in turn, the cost and availability of money and credit in the U.S. economy. The FOMC also directs System operations in foreign currencies. (The Federal Open Market Committee, 2001)

The current Chairman of the Board of Governors is Dr. Alan Greenspan. He is also the chairman of the FOMC. From 1974 to 1977, he was the Chairman of the Presidential Council of Economic Advisors for President Ford. Then in

1981, he became the Chairman of the National Commission on Social Security, a position he held for three years. (Members of the Board, 2001) He was appointed to the Board of Governors in August of 1987 to fulfil an un-expired spot. Dr. Greenspan was re-appointed in February of 1992 for a full fourteen-year term. Throughout his political career, Alan Greenspan has dealt with many economic slowdowns and recessions.

What exactly is a recession though? The most common definition of a recession is two consecutive quarters of decline. Although definition deals with a decline in GDP, some economics feel that simply a decline is not ample description of what a recession should be defined as. Some

feel that it should be defined as a period when the unemployment rate rises by at least one percentage point that is when GDP growth falls significantly below its potential rate . (Don t Mention the R-Word, 2001, p.22)

The United States economy is not officially in a recession. Throughout 2000, the net worth of American households fell for the first time in fifty years. (Can the World Escape Recession, 2001, 21) The Conference Board index sank to 106.8 in February [of 2001] The University of Michigan index has fallen 15.8 points since November [2000]. (Morris, 2001, p.44) The Purchasing Managers index dropped 43.7% in December 2000. This was its lowest point since the recession of 1990-1991. Based on historical averages, if it drops below 42.8% then we are in an economic recession. (Cooper, 2001, 29) Therefore although the economy is not in a recession, yet it is definitely slowing down and possibly headed towards a recession. The job of the Federal Reserve, then, is to boost the economy.

In order to achieve this end, the Federal Reserve board of Directors can decrease the discount rate. The Fed charges this rate when it loans another bank money. By lowering the discount rate, the Fed changes the cost of

money for banks and therewith [increasing the] incentive to borrow . (Schiller, 2000, p.278) The Fed has been lowering this rate since January 3rd in order to induce spending.

On January 3rd, the Federal Reserve Board approved a discount rate of 5.5%. This lowered the rate by 25 basis points, 1/4 of a point for all districts. Then on the thirty-first of January the Fed approved the lowering of the discount rate in the Boston and Richmond to a rate of 5%. The Federal Reserve Board approved a discount rate of 5% for the Federal Reserve Bank of Kansas City on February first. Then on March 20th, the Board of Governors approved a 50 point reduction in the discount rate to 4- + percent. (Press Release March 20, 2001, 2001) On April 18, the Board of Governors approved another reduction to 4% for nine of the twelve districts. (Press Release April 18, 2001, 2001)

By cutting the discount rate the Federal Reserve Board hopes that banks will be more willing to loan money out to consumers. The theory behind this is that, since the banks are receiving their money at lower rates they will be more lenient about giving loans to consumers. The cost of the loan will be low as well, which will entice more people to borrow. The borrowers will then consume or invest this money which should boost the economy.

Although, the Federal Reserve has no control over taxes, it still can influence tax bills and taxes themselves. President Bush is currently trying to get his tax cut passed through Congress. The House of Representatives recently passed a bill, which would total $5.6 billion. (Samuelson, 2001, p.29) The next step is to have the Senate pass it as well.

Alan Greenspan supported this tax cut. He told the Senate Banking Committee that a tax cut would help the economy, if it slipped into a recession. (Greenspan, O Neil Push for Tax Cut, 2001) The money would be given back to consumers, who would then re-invest the money back in the economy. Hence, Alan Greenspan endorsed this policy since it would help boost the slowing economy.

The Federal Reserve is also lowering its Federal Funds rate target in order to boost the economy. The Federal Funds Rate is the interest rate for interbank reserve loans. On January 3rd, January 31st, March 20th, and April 18th the FOMC lowered this rate by a half of a point each time. By lowering this rate, the Fed hopes to put more money in consumer s pockets and lower corporate borrowing costs, [thus] helping corporate profits . (Berenson, 2001, C1) The theory behind this is similar to that of cutting

the discount rate. If it costs banks less to borrow, then they will be more likely to give out more loans. This loaned money would then re-enter the economy through investment and consumption, which would lead to an increase in the gross domestic product.

These interest rate cuts had varying effects on the stock market. The day of the first announcement caused the Dow Jones Industrials, the NASDAQ, and the Standard and Poor s indexes to increase. After the January 31st announcement, the Dow Jones increased by .1% while the NASDAQ decreased by 2.3% and Standard and Poor s decreased by .6%. All three indexes fell on the day of the March 21st rate cut. The Dow lost 2.4%, the NASDAQ lost 4.8%, and the S & P lost 2.4%. (Berenson, 2001, C1) After the most recent cut of the Federal Funds rate, the Dow Jones rose 3.9%, the NASDAQ rose about 8.1%, and the S & P rose by 4.5%. (Market Scoreboard, 2001, E5)

The Federal Reserve System has two main goals. They are price stability and sustainable economic growth. The economy is definitely slowing down. This was caused by the cyclical nature of a market economy and heavy borrowing by households and companies . (When America Sneezes, 2001, p.66) Although, the first quarter of 2001 is not over yet,

many experts believe that first quarter earnings will not be positive. Therefore, it is the job of the Federal Reserve System to increase and/ or boost the economy. The Fed is cutting its Federal Funds target rate and its discount rate. The Fed chairman, Alan Greenspan, is endorsing a tax cut plan, which would put money into the hands of the consumer.

It is the belief of the author that the Federal Reserve will be unable to prevent the United States from entering into a recession. Although it is cutting its rates on money , people are already heavily in debt. Many companies are in the same situation. Although the price of money is low, they would rather pay off outstanding debt rather than incur more. Hence cutting of the Federal Funds rate and the discount rate would be passed onto consumers they are not taking advantage of it. This then is not helping to boost the economy.

The tax cut proposed by George W Bush is also probably not going to help the economy. It the bill does get passed then, it would take a while to institute it. By that time, it is possible that the recession will be over and the tax break will have come too late. Another possible problem is that the proponents of this tax break are assuming that the

next few years will be like the past four to five years, and that there will be a surplus instead of a deficit. Unless this bill is ratified soon and put to work for the consumer quickly then this will have no effect on boosting the economy.

The economy is definitely slowing down and is possibly entering a recession. If this happens, then the price of money will lower and the unemployment rate will most likely rise. A possible hope is for consumer confidence to grow and for them to start spending money again. This would bolster the economy. Therefore it is the author s belief that although the Fed is working to combat the possibly imminent recession with its customary tools, it would do better if they were able to build up consumer confidence.

Will the United States actually enter into a recession? Will the Federal Reserve System be able to right this slump? Only time will tell.

References

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