Question

1. Periodically, a Senator or Congressman submits legislation to bring the Federal Reserve under the direct control of Congress.  Thinking about the policy objectives of the Federal Reserve System, explain why an independent central bank might more effectively achieve its policy objectives.

2. The simple models that we develop in class suggest that both fiscal and monetary policy work smoothly to eliminate short-run fluctuations in real GDP and achieve stable price growth. In reality, policy implementation may not be as effective as our model suggests. What obstacles might inhibit the effectiveness of fiscal and monetary policy? You should discuss one obstacle that both monetary and fiscal policy must overcome, one obstacle unique to fiscal policy, and one obstacle unique to monetary policy.

Answer 1

Answer to Part 1)

The Federal Reserve was established in the year 1913 to make sure that the economy does not have serious fluctuations in which people head out to banks to withdraw all their money due to lack of investor confidence, which was a common happening before the existence of the institution. It was independent because the flow of money is an extremely important consideration which at all times must remain away from political bias.

The Federal Reserve has numerous tools to tackle a situation of inflation or recession in the economy such as revising the interest rates it charges from commercial banks or changing the ratio of money which the banks must hold at all times or sell or purchase bonds which directly changes the flow of money in the economy.

The core reason as to why the federal reserve has been kept independent and away from direct government control is the fact that political considerations may demand the federal reserve to take actions which may not be good for the economy. For example, when election are close, the political considerations may demand to reduce the interest rates, to please the consumers as well as producers so that they favour the government, But during this time period, if the inflation rate is high or the prices of goods and services is high in the economy, doing such things will dampen the economy too much and thus independence becomes necessary as taking such actions would have long term impacts on the economy of a nation.

We can conclude by saying, that to avoid the ill effects of a bad political decision with regards to the demand and supply of money, the Federal Reserve has been made an independent agency, which has produced great results for the United States, examples of which are the recession in 2008 which could not have been corrected without the Federal Reserve’s support. In the absence of this very independence, the economy may be subjected to political considerations in regulating the flow of money which may cause serious problems and instability.

Answer to Part 2)

Fiscal Policy: -

The fiscal policy is the governments way of regulating the economy. It does so by altering key aspects of the economy such as taxation and government spending. For example, during an economic recession, the Fiscal Policy adopts the policy of reducing the tax rates and increasing government spending which in turn increases the supply of money in the economy and helps in ensuring that the economy can return back to its original position.

The major obstacle, which Fiscal Policy faces in terms of being able to correct the economy is the rise in debt due to increased spending or reduced taxes as indicated above during a recession cycle.

For example, when the economy is in deep debt, even though the economics indicate increasing the supply of money by borrowing, or by reduction in taxes and increasing government spending, the government may already be in debt or may not have the required resources to undertake such expansion in the economy.

Monetary Policy: -

The monetary policy is the federal reserve’s way of regulating an economy, it does so by revising the interest rates it charges from commercial banks or through sale or purchase of bonds or through revision in the reserve requirements.

However, the core shortcoming is that it cannot force people to spend more or less nor can it force banks to increase or reduce the supply of money directly. It can only regulate interest rates and expect the banks or consumers to react to it. The reaction is up to the consumers to choose from.

For example, if the central bank reduces the interest rates, it is up to the banks, if they want to extend the same to the consumers or not and up to the consumers or producers if they want to increase their spending or not.

Please feel free to ask your doubts in the comments section if any.