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fede foreign currency operations. Purchases and sales of foreign currency by the Fed are directed by the FOMC, acting in cooperation with the Treasury, which has overall responsibility for these operations. The Fed does not have targets, or desired levels, for the exchange rate. Instead, Fed intervention aims to counter disorderly movements in foreign exchange markets. Intervention operations involving dollars, whether initiated by the Fed, the Treasury, or by a foreign authority, are not allowed to alter the supply of bank reserves or the funds rate. The process of keeping intervention from affecting reserves and the funds rate is called the “sterilization” of exchange market operations. These are not used as a tool of monetary policy. The Point of implementing policy through raising or lowering interest rates is to affect people’s and firm’s demand for goods and services. For the most part, the demand for goods and services is not related to the market interest rates quoted on the financial pages of newspaper, known as nominal rates. Instead, it is related to real interest rates—nominal interest rates minus the expected rate of inflation. Monetary policy can affect real interest rates in the short run. Changes in real interest rates affect the
public’s demand for goods and services mainly by altering four things: borrowing costs, the availability of bank loans, wealth of households and businesses, and foreign exchange rates. Lower real rates and a healthy economy may increase bank’s willingness to lend to businesses and households. This may increase spending, especially by smaller borrowers who have few sources of credit other than banks. Lower real rates make common stocks and other such investments more attractive than bonds another debt instruments; as a result, common stock prices tend to rise. Households with stocks in their portfolios find that the value of their holdings has gone up, and this increase in wealth makes them willing to spend more. In the short run, lower real interest rates in the US also tend to reduce the foreign exchange value of the dollar, which lowers the prices of the exports sold abroad and raises the prices of foreign produced goods. Expansionary monetary policy also raises aggregate spending on US produced goods and services by improving the balance of trade. A monetary policy that constantly attempts to keep short-term real rates low can lead to high inflation and higher nominal interest rates to protect the purchasing power of the funds due to them. This is the reason that economic activity can not keep expanding beyond its potential level. Initially, the low real interest rates will cause business and households to increase their borrowing demands, and that will push up other longer-term interest rates. These tighter credit conditions will tend to cause real interest rates to rise despite the Fed’s attempts to keep them low, thereby slowing economic activity, moving it back toward its potential level (Eisner 25). The precise magnitude and timing of the effects of the Fed’s actions on the economy are never perfectly predictable. This is partially because the future course of the economy is subject to many influences beyond the Fed’s control, such as government taxing and spending policies, the availability of natural resources like oil, economic developments abroad, financial conditions at home and abroad, and the introduction of new technologies. In addition, human responses to economic incentives are inherently difficult to predict, and may change over time, leading to errors in predicting private aggregate spending (Rukeyser 124). Monetary policy alone cannot perform an economic miracle. It cannot eliminate all fluctuations of the business cycle; it cannot revitalize an outdated industrial machine; it cannot reform and reduce an overblown, arrogant bureaucracy; but it can perform stabilizing functions crucial to the economy of the United States of America. Bibliography Eisner, Robert. How Real is the Federal Deficit? New York, The Free Press, 1986. “Federal Reserve System.” World Book Encyclopedia. Vol. 7, 67-68, 1988. Rukeyser, Louis. What’s Ahead for the Economy: The Challenge and the Change. New York, Simon and Schuster, 1983. Segalstad, Eric V. “Determinants of the Interest Rate.” October, 1997. Sims, C., “Comparison of Interwar and Post-War Business Cycles: Monetarism Reconsidered.” American Economic Review, 1980.
Bibliography Eisner, Robert. How Real is the Federal Deficit? New York, The Free Press, 1986. “Federal Reserve System.” World Book Encyclopedia. Vol. 7, 67-68, 1988. Rukeyser, Louis. What’s Ahead for the Economy: The Challenge and the Change. New York, Simon and Schuster, 1983. Segalstad, Eric V. “Determinants of the Interest Rate.” October, 1997. Sims, C., “Comparison of Interwar and Post-War Business Cycles: Monetarism Reconsidered.” American Economic Review, 1980.