Question

Why does the Fed buy government securities during a recession?

a. If the economy is facing rising levels of inflation, what would the Fed do with its three monetary control tools?

b. What was the original intent of the Federal Reserve Act of 1913? What are the limitations to the Fed’s independence?

Answer 1

Before we proceed to answer why the Fed buys government securities during a recession, we need to understand what recession is.

Recession in an economy is said to occur when there is a significant decline in the real GDP, income, manufacturing, retail sales and employment and the decline occurs for at least six months. The first sign of a recession is when there is slowdown or decline in manufacturing jobs.

During a recession, with a reduction in jobs, people lose or suffer a reduction in income. With a loss or reduction of income, their ability to spend on goods and services lessens. This further impacts other industries and firms as demand for their goods and services decline. Thus starts the vicious cycle of reduced income and reduced demand.

This is where the Fed steps in. When the Fed buys government securities from the market, it releases cash and thus pumps up the purchasing power of the people. With money supply in hand, people are expected to generate a demand for goods and services, thereby boosting manufacturing, generation of employment and wages. This policy of Fed' buying government securities follows the proposition by John Maynard Keynes during 1930s to all governments in general, to combat the Great Depression.

(a). When Economy faces rising levels of Inflation - There is a general increase in the price of goods and services and a lowering of the purchasing power of the currency. To control inflation, the Fed would use the below 3 tools of monetary policy:

(i) Bank Rate Policy - ?This is one of the most widely used monetary tool for controlling inflation. When the Fed increases the bank rate (Fed Funds Rate) , it causes an increase in the cost of borrowing money by commercial banks from the Federal Reserve, thereby reducing the supply of money from the central bank to the commercial banks. This means the commercial banks have less money to supply to the public and they will supply the money to the public at higher interest rates. In such a case, fewer people want to borrow money. With less money supply in hand, the public reduces spending, which then lowers a demand for goods and services and thereby reduces the price and consequently inflation. One finds with increase in interest rates, people save more to take advantage of higher interest rates.

?(ii) Cash Reserve Ratio (CRR) : The second tool the Fed uses is to increase the reserve requirements that determines the amount of money commercial banks need to keep on hand to cover withdrawals. This is also known as Cash Reserve Ratio. The higher the CRR, the less the amount of cash commercial banks have to lend to public. This reduces consumer borrowing and thereby consumer spending and consequently inflation.

(iii) Open Market Operations: This is the 3rd monetary policy tool that Fed can use. In open market operations, Fed, conducts purchase and sale of government securities. When government securities are sold to the public, there is a reduction in money supply in public hands. In addition to selling government securities, Fed can offer an increase in interest paid on bonds, to induce more people to invest in these.

(b) Federal Reserve Act 1913 - Federal Reserve System got establised as the central bank of the U.S through the Federal Reserve Act of 1913. The act set out the structure, purposes and functions and accountability of the Fed. It offered the country a stable, flexible and reliable monetary and financial system. Limitations to Fed's independence arises due to the fact that the Congress has the power to amend the Federal Reserve Act. It has done so a few times in the past. So far, the policies have not had a serious impact on Fed's independence from politics and the Fed continues to enjoy its independence. But all depends on the nature of the Congress and Senate that sits in power of the day. There are schools of thought that argue that Fed's monetary policy functions may be unconstitutional but there is judicial impartiality in this matter. This sits in the decision of the Congress.