Federal Reserve’s Monetary Policy

Federal Reserve’s Monetary Policy

Impact of Monetary Policy Changes on Investment

Federal Reserve monetary policy changes constitute strategies based on the amount of money circulating in the economy and can significantly affect investment. Foremost, it is worth noting that monetary policy can be expansionary or contractionary. The former seeks to accelerate economic growth, while the latter strives to restrict economic growth (Engen et al., 2015). The Federal Reserve may adopt a restrictive policy by raising short-term interest rates to cool economic growth when it grows too fast and the inflation rate increases (Engen et al., 2015). On the other hand, the Federal Reserve may lower short-term interest rates in the face of a sluggish economy to stimulate growth and achieve economic recovery (Engen et al., 2015). These policy changes affect investment directly or indirectly. The first case is through the direction and level of interest rates, while the indirect effect occurs via expectations regarding inflation. These adjustments affect the prices of primary asset classes, such as currencies, cash, bonds, commodities, equities, and real estate (Engen et al., 2015). An increase in the prices of assets increases investment, while a decline reduces investment levels.

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Effectiveness of Countercyclical Monetary Policies

The Federal Reserve’s countercyclical monetary policies have effectively countered business cycle swings. Financial intermediaries often raise their credit standards while risk-averse investors switch from stocks and bonds and move into government and cash securities (Chatterjee, 2022). These practices reduce the amount of credit available to the private non-financial sector, ultimately raising interest rates charged on loans. Severe credit cutbacks lead to widespread business failure and, consequently, credit cutbacks and bankruptcies. However, countercyclical monetary policies usually restore investor confidence in the ability of financial markets to rebound. In the face of adverse events, three countercyclical policies typically come into play, namely: insuring financial institutions up to $100,000; the Federal Reserve acting as the lender of the last resort; and invoking the countercyclical interest rate policy, which raises and slows down interest rates accordingly (Chatterjee, 2022). The insurance approach protects small depositors from bankrupt banks during downturn periods. The lender of the last resort approach arranges loans that enable liquid but solvent financial institutions to repay their loans to the banking system. On the other hand, the interest rate policy makes it easier for households and businesses to service their loans and less necessary for investors and banks to cut back drastically on credit in the next phase of the business cycle (Chatterjee, 2022). For these reasons, the countercyclical monetary policies effectively counter business cycle swings.

References

Chatterjee, S. (2022). Natural Business Cycles: A Legacy of Countercyclical Policies: Are policies exacerbating the swings in business cycles? Federal Reserve Bank of Minneapolis. Retrieved from https://www.minneapolisfed.org/article/1999/real-business-cycles-a-legacy-of-countercyclical-policies.

Engen, E., Laubach, T., & Reifschneider, D. (2015). The Macroeconomic Effects of the Federal Reserve’s Unconventional Monetary Policies (pp. 1-54). Washington: Board of Governors of the Federal Reserve System. Retrieved from https://www.federalreserve.gov/econresdata/feds/2015/files/2015005pap.pdf

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Federal Reserve’s Monetary Policy

Discuss how changes in the Federal Reserve’s monetary policy affect at least 1 of the four components of GDP (consumption, investment, government spending, net exports).
Have the Federal Reserve’s countercyclical monetary policies effectively moderated business cycle swings? Justify your response.

Reply to at least 2 of your classmates or your faculty member. Be constructive and professional. (See the file for the two discussions to respond to.)