The Role and Effectiveness of the Federal Reserve in Stabilizing the Economy
Describe the ways in which the Federal Reserve adjusted monetary policy tools in response to the financial crisis of 2007–2009; assess the success or effectiveness of those adjustments.
The Federal Reserve implemented several programs during the 2007-2009 financial crisis to support the liquidity of financial institutions and improve conditions in the financial markets. The first set of tools is related to the Fed’s role as the lender of the last resort and includes the Term Auction Facility (TAF), the Term Securities Lending Facility (TSLF), and the Primary Dealer Credit Facility (PDCF). TAF was used to increase liquidity by allowing the central bank to auction a number of set-term funds to depository accounts in credit unions, credit banks, and commercial banks (Board of Governors of the Federal Reserve System, 2022). Eligible participants could borrow under the primary credit program and participate in collateral-backed short-term loan auctions. TAF helped distribute liquidity at a time of elevated pressure in short-term funding. The program was successful as all funds were allocated to all bids satisfactorily, and all credit made under the depository facility was repaid in full per the existing terms and conditions. Similarly, the Fed established TSLF as a weekly lending facility to promote liquidity in the Treasury and other collateral markets (Board of Governors of the Federal Reserve System, 2022). The program allowed primary dealers to borrow Treasury securities from the open market trading desk by pledging eligible collateral. However, TSLF harmed the value of the dollar and went against the Fed’s objective to avoid affecting security prices, leading to its halt in October 2009 (Board of Governors of the Federal Reserve System, 2022). The Federal Reserve also implemented PDCF to provide overnight loans to American households and businesses. The idea was to facilitate smooth market functioning, stabilize the country’s financial systems, mitigate foreclosures, and restore economic growth. These tools were implemented under the discount window system to relieve liquidity strains by funding the banking system and depository facilities.
The second set of tools the Fed utilized to respond to the financial crisis is tied to providing liquidity directly to investors and borrowers. One of these is the Commercial Paper Funding Facility (CPFF), which was created as a special-purpose vehicle to ensure liquidity in the commercial paper markets through the flow of credit (Board of Governors of the Federal Reserve System, 2022). The crisis created uncertainties that prompted the Federal Reserve to implement CPFF to eliminate rollover risk, which resulted in issuers being unable to repay investors. CPFF served as a liquidity backstop and effectively created a positive spillover effect by lending eligible banks to repay their borrowers and investors (Wiggins, 2020). Essentially, the policy tool enabled dealers to facilitate credit availability and support smooth market functioning. The Fed also implemented the Money Market Investor Funding Facility (MMIFF) to raise liquidity available for money market investments. The Fed loaned 90% of the purchase of the highly-rated money market instruments to special purpose vehicles, which, in turn, issued asset-backed commercial paper to offset the remaining portion of the asset’s purchase price (Board of Governors of the Federal Reserve System, 2022). The instruments helped money market funds to uphold their appropriate liquidity conditions while cushioning short-term debt markets from pressure to an increased number of short-term investments.
The third instrument involved expanding the traditional Open market operations (OMO) tool to ensure liquidity in the money market. OMOs are concerned with purchasing and selling short-term Treasuries and securities in the open market by the central bank (Board of Governors of the Federal Reserve System, 2011). OMOs ensured the functioning of credit markets through a constant flow of vast sums of money. The objective was to enable financial institutions, such as banks, to meet customers’ demands by keeping their cash reserves high enough (Board of Governors of the Federal Reserve System, 2011). The Fed used OMOs to purchase longer-term securities using newly created money, accommodating broader financial conditions. At the same time, this tool equipped the Fed to sell its securities to reduce money in circulation, putting downward pressure on long-term interest rates (Board of Governors of the Federal Reserve System, 2011). As a result, OMOs were effective in making broader financial conditions. Additionally, the high purchase of long-term Treasury security supported robust economic recovery. As such, OMOs maintained an inflation rate consistent with the Federal Open Market Committee’s dual mandate of achieving maximum employment and price stability.
Assess to what extent the financial crisis of 2007–2009 compromised the independence of the Federal Reserve.
The Federal Reserve created new liquidity facilities at the height of the financial crisis through credit policies, compromising its independence. The independence of the Federal System is thanks to the autonomy that insulates it from short-term political pressure (Levy Economics Institute, 2014). This independence allows the Fed to implement excessively expansionary economic policies and engage in macroeconomic decision-making that encourages economic growth. However, in the face of the 2007-229 financial crisis, the Federal Reserve created new liquidity facilities (Levy Economics Institute, 2014). A significant number of these institutions were new recipients beyond depository institutions. In combating financial instability, the Fed collaborated with the Treasury to provide extraordinary bail-out loans to various institutions. For instance, the Fed’s participation in the bail-out of Bear Sterns shows that it was not insulated against short-term political pressure. Notably, the Federal Reserve helped JP Morgan Chase’s acquisition of Bear Stearns by allocating a $30 billion non-recourse loan with a $1 billion deductible (Hubbard et al., 2009). In addition to this, the Fed provided credit to particular market segments at the expense of others. A case in point is the Fed’s collaboration with the Treasury and the Federal Deposit Insurance Corporation to dispose of bad assets belonging to Citigroup and Bank of America by guaranteeing $424 billion (Levy Economics Institute, 2014).
These monetary policy adjustments negatively affected the Fed’s balance sheet. As the lender of the last resort, the Fed increased the risk for the central banks. It posed moral hazards for borrowers since total assets in its balance sheet had escalated to over $2000 billion as of June 2007 compared with $852 billion in the previous financial year (Hubbard et al., 2009). Furthermore, Treasury securities comprised only 29% compared with 91 % in the previous year (Hubbard et al., 2009). The government’s decisions to bail out Bear Stern, Citigroup, and Bank of America and discriminate on market segments seriously compromised the Fed’s independence.
Analyze the strengths and weaknesses of using monetary policy versus fiscal policy when promoting economic activity and preserving price stability (385)
The government usually adopts a monetary policy and fiscal policy as the primary tools for influencing macroeconomic outcomes. The earlier policy focuses on managing central banks’ interest rates and money supply (Board of Governors of the Federal Reserve System, 2011). On the other hand, the latter policy is concerned with how the Federal government earns money through taxation (Board of Governors of the Federal Reserve System, 2011). Despite the debate on the best tool for stimulating economic growth between monetary and fiscal policy, both have strengths and weaknesses. Implementing monetary policy can take two approaches: expansionary, which lowers the interest rates, or contractionary, which raises interest rates. The Fed may tighten monetary policy to discourage consumption and investment by forcing up interest rates or inspire consumption and investment by reducing interest rates. One advantage of this policy is that it controls the money circulating in the economy, eventually balancing macroeconomic factors, such as economic growth, inflation, consumption, and overall liquidity. Monetary policy also allows the government to purchase or sell Treasury securities, revise the amount of reserves in banks, and regulate foreign exchange rates. The primary metric for monetary policy is the rate of inflation. Thus, the monetary policy balances economic growth and inflation to achieve a stable rise in gross Domestic Product (GDP), maintain forex, predictably maintain inflation, and keep unemployment low.
Despite these advantages, monetary policy has several disadvantages. One of these is that monetary policy does not guarantee economic recovery, especially during an economic recession. Ideally, not all consumers will have the confidence to take advantage of low interest rates to spend more. Monetary policy is also faulted for discouraging the expansion of businesses. Illustratively, a contractionary monetary policy increases interest rates, limiting businesses from expanding their operations. In effect, this state of affairs may lead to high prices and low production. These businesses may take a prolonged period to revamp their businesses, with others being forced to shut down.
Comparatively, fiscal policy influences macroeconomic conditions through government spending and tax policies. Some of these macroeconomic conditions include economic growth, supply and demand, employment, and inflation (Board of Governors of the Federal Reserve System, 2011). The policy’s philosophical premise is that government interventions are the only solutions to steer the economy. Empirical evidence available supports the crucial role of fiscal policy in stimulating economic activities in the short run by increasing aggregate demand (International Monetary Fund, 2015). In this way, the fiscal policy increases spending and creates an easy money environment, generating jobs while stimulating the economy. According to the International Monetary Fund (2015), fiscal policy effectively mitigates economic fluctuations by targeting inflation through aggregate demand, spillover from public wages into the private sector, and impacting taxes that affect private consumption and marginal costs (International Monetary Fund, 2015). Fiscal policy can be used to mitigate endless cycles of low GDP expansion and rotating interest rates. Expansionary efforts stimulate the economy as they influence the contraction and expansion of GDP as a measure of economic health.
However, there is a domino effect when fiscal policy measures are used. To illustrate, the government can accumulate excess debt when spending faster than tax revenues. This phenomenon is because the Federal government finances the spending by issuing interest-bearing bonds, consequently raising the national debt. Another long-term disadvantage of fiscal policy is that it raises interest rates indirectly (Board of Governors of the Federal Reserve System, 2011). A worthwhile explanation behind this situation is that the government’s expansionary fiscal policy leads to issuing bonds in open markets, posing competition with the private sector, which might also issue bonds simultaneously. Therefore, the fiscal policy makes borrowers incur higher interest expenses, dragging the economic expansion in the long run. Additionally, the fiscal policy makes commodities more expensive to export and foreign-based commodities cheaper to import in the long run. Typically, fiscal efforts compel foreign investors to bid up local currency to invest in open markets (International Monetary Fund, 2015). Although this scenario has positive effects in the short term, it renders local goods more expensive to export. This state of affairs is that price is the reason consumers’ purchasing practices are highly influenced by price. As a result, increasing the purchase of foreign goods and a decline in demand for local goods lead to a temporary trade balance. Based on the findings, using a single policy instrument may not effectively foster economic growth. Moreover, long-term use of fiscal interventions is ineffective since hard assets, such as long-life assets or infrastructure, remain standing at the end of multiple economic cycles.
Describe one anticipated result or economic consequence of the Fed’s actions and the extent to which it actually occurred (385)
The Fed’s negative interest rate may result in massive currency hoarding. The Fed implemented a negative interest rate to respond to the 2007-2009 financial crisis. Notably, the Federal Open Market Committee (FOMC) cut the short-term interest rate by 5.1% (Labonte, 2021). Usually, investors tend to rush to protect their wealth in the event of a financial crisis. This creates a vicious cycle where the more people hoard, the more conventional assets are sold off, and the greater the pressure to hoard. This cycle creates more compulsion to hoard currency, impairing the valuation of all asset classes. The financial market then faces a shortage of safe assets since there is no safe place to hoard the remaining currency, posing the risk of impairing capital. The heightened demand for safety assets eventually leads to capital destruction, forcing investors to crowd each other for the opportunity to put their capital in safety. This situation may also compel investors to start outbidding each other beyond the purchasing price of the securities, motivating them to give out a portion of their capital so as not to lose all. Consequently, money in the capital market decays, with positive private market yields pre-empting economic policy changes.
Describe one unintended consequence (such as economic, social, or political) of the Federal Reserve’s actions
One anticipated consequence of the Fed’s intervention efforts in the 2007-2009 financial crisis is the concept of moral hazard. Here, moral hazard refers to the concept that people will act responsibly if they do not anticipate fully bearing the negative consequences of their actions (Labonte, 2021). A moral hazard could come forth during the financial crisis if the policy tools and instruments created an impression that the Federal Reserve would intervene in future market crises to cushion participants in the financial markets from massive losses. Consequently, this expectation would motivate customers to take greater risks pursuing larger profits. For instance, lowering interest rates to stimulate interest-sensitive spending during the crisis created an expectation that the Fed would bail customers and institutions out in the future (Labonte, 2021). This concept is an economic problem since it leads to inefficient allocation of resources. For instance, the government may bail out big financial institutions, such as banks, at the expense of small financial facilities, such as microfinance institutions. Conversely, the Fed’s action could make future economic downturns more likely if its actions to curb the crisis led to greater risk-taking.
References
Wiggins, R. (2020). The Commercial Paper Funding Facility (U.S. GFC). The Journal of Financial Crises, 2(3), 174-200. Retrieved from https://elischolar.library.yale.edu/cgi/viewcontent.cgi?article=1082&context=journal-of-financial-crises.
Levy Economics Institute. (2014). Federal Reserve Bank Governance and Independence During Financial Crisis(pp. 4-128). Ford Foundation. Retrieved from https://www.levyinstitute.org/pubs/rpr_4_14.pdf
Labonte, M. (2021). The Federal Reserve’s Response to COVID-19: Policy Issues(pp. 1-35). Congressional Research Service. Retrieved from https://crsreports.congress.gov/product/pdf/R/R46411
International Monetary Fund. (2015). IMF Policy Paper: Fiscal Policy and Long-Term Growth(pp. 4-62). Washington, D.C. Retrieved from https://www.imf.org/external/np/pp/eng/2015/042015.pdf
Hubbard, G., Scott, H., & Thornton, J. (2009). The Federal Reserve’s Independence Is at Risk. Brookings. Retrieved from https://www.brookings.edu/opinions/the-federal-reserves-independence-is-at-risk/.
Board of Governors of the Federal Reserve System. (2011). Monetary Policy Report to Congress(pp. 4-52). New York, USA. Retrieved from https://www.federalreserve.gov/monetarypolicy/files/20110301_mprfullreport.pdf
Board of Governors of the Federal Reserve System. (2022). Federal Reserve Board – Term Securities Lending Facility. Board of Governors of the Federal Reserve System. Retrieved from https://www.federalreserve.gov/monetarypolicy/tslf.htm.
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Question 
The Role and Effectiveness of the Federal Reserve
Overview
The Federal Reserve offers to the general public numerous publications available on the Publications page of the Federal Reserve Board website.
The Federal Reserve Board testimonies, press releases, monetary policy reports, the Beige Book, and a variety of other publications offer a detailed assessment of current economic activity, financial markets, and the monetary policy tools used to promote economic activity and preserve price stability.
Preparation
Go to Publications on the Federal Reserve Board website. Under the Monetary Policy menu, explore the monetary policy tools. Notice that the first four in the list are considered conventional tools. The remaining tools in the list are non-conventional.
Instructions
Write an 8–10 page paper in which you evaluate the role and effectiveness of the Federal Reserve in stabilizing the economy since the 2007–2009 recession and its continued impact on the current state of the economy. In your paper:
Describe the ways in which the Federal Reserve adjusted money policy tools in response to the financial crisis of 2007–2009; assess the success or effectiveness of those adjustments.
Assess to what extent the financial crisis of 2007–2009 compromised the independence of the Federal Reserve.
Analyze the strengths and weaknesses of using monetary policy versus fiscal policy when promoting economic activity and preserving price stability.
Describe one anticipated result or economic consequence of the Fed’s actions and the extent to which it actually occurred.
Describe one unintended consequence (economic, social, or political) of the Federal Reserve’s actions.
Use data from the Fed publications and other sources to support all of your positions. Cite at least four academic-quality references.
Include a cover page containing the title of the assignment, the student’s name, the professor’s name, the course title, and the date. The cover page and the reference page are not included in the required assignment page length.
This course requires the use of Strayer Writing Standards. For assistance and information, please refer to the Strayer Writing Standards link in the left-hand menu of your course. Check with your professor for any additional instructions.
The specific course learning outcome associated with this assignment is:
Evaluate the impact of the Federal Reserve on the state of the economy.