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U.S. Federal Reserve Monetary Policy

U.S. Federal Reserve Monetary Policy

Examining recent U.S. Monetary Reports to Congress, it seems reasonable to argue that the overall state of the U.S. economy is in deep trouble. While the report notes that strong growth has been indicated in a number of business sectors across the country-i.e. housing, manufacturing and construction-the reality is that these surges have not been enough to hold down the unemployment rate. What this effectively suggests is that while the economy is showing some signs of recovery from the recession, in the short-term, the growth that is being produced is not stable. Given that the Federal Reserve is actively involved in ensuring short-term recovery for the U.S. economy, what this effectively means is that the Federal Reserve still has a long road ahead.

The U.S. Federal Reserve Bank is in charge of setting monetary policy for the United States. The Federal Reserve policy is either expansionary or contractionary. Expansionary policy involves increasing money supply and reducing interest rates, whereas contractionary policy entails reducing money supply and increasing interest rates. The traditional policy of the Federal Reserve during the past three decades has been to preempt inflation. That is, the Federal Reserve has attempted to slow economic growth in order to stabilize prices and prevent inflation from rising. The usual policy of contractionary monetary (reducing money supply or raising interest rates) was unsuccessful in curbing inflation. These policies are traditionally done through open market operations through buying and selling government bonds or through setting interest rates.

However, the US Federal Reserve's contractionary policy has become increasingly marginalized during the last two years.It gave way to the policy of maintaining economic growth, rather than slowing down inflation.Therefore, it is obvious that the Federal Reserve seems to abandon its traditional policy of containing accelerated inflation.

Therefore, during the last two years the Federal Reserve seems to follow an expansionary fiscal and monetary policy. Previously, especially during the last three decades, the Federal Reserve adopted the opposite policy, which is a contractionary policy.

The simple answer to whether inflation is still a threat is yes.First, the answer is yes because the idea that we are in an imminent deflationary period is controversial. Secondly, as stated earlier, deflation could be beneficial to the economy and therefore, the benefits reaped from deflation can be used to reverse the course of the economy and trigger inflation.For example, the lower interest rates and the tax cuts could cause the economy to boom (in form of increased spending and increased employment) and therefore it could trigger inflationary pressure. In sum, inflation is still a real threat to the U.S. economy.

There are three main factors that could cause inflation:

  • Demand-pull inflation: Demand-pull inflation is inflation triggered by the increase of the demand for goods and services.
  • Cost-push inflation: Cost-push inflation is inflation caused by the supply side of economy. That is, it is caused by an increase of wages and inputs used by the producers.
  • Inflation related to adaptive expectations: this form of inflation is based on the price-wage spiral where the worker expectation of higher prices urged them to demand higher wages and the increase in higher wages will force the producer to increase the price.

As stated earlier, deflation is the opposite of inflation, which is a decline in the general price level. Therefore, it affects different segments of the economy in different ways. The decline in the price will harm the producer because of lower revenues and hence, lower profits. Also, deflation harms workers because lower prices will force the employer to lower the wages or reduce employment (or workforce). Government also could be harmed by deflation because lower employment and lower profitability means lower taxes. Lenders will be harmed because of a lower interest rate (according to mainstream economists).On the other hand, consumers gain because of lower prices. Foreign importers gain because of lower prices. According to the mainstream economists, potential investors could benefit because of the lower interest rates.

According to the Classical Monetarist theories, deflation is a lower price and the lower price will increase the real money supply and thus will reduce the interest rate. The reduction in the interest rate will increase investment.On the other hand, according to the Keynesian theorists, the reduction in the price will reduce the money supply and the reduction in the money supply will increase the interest rate and thus reduce investment .

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