Complexities of US financial system

Assignment 1: Complexities of the US Financial System

Describe how the US financial markets impact the economy, businesses, and individuals.

US financial markets play an important role in contributing to the health and efficiency of the economy, businesses, and individuals. (Spiegel, 2002) Because there is a strong relationship between the health of the economy and financial market development and economic growth, even a slight dip in the financial markets can radically effect how the economy, businesses, and individuals respond. (Ask Dr Econ, 2005) Financial markets “facilitate the raising of capital in the capital markets, the transfer of risk in the derivatives market, price discovery, global transactions with integration of financial markets, the transfer of liquidity in the money markets, and international trade in the current markets.” (Financial Markets, 2013) When the financial markets are doing well, “firm-level, industry-level, and cross-country studies all suggest that the level of financial development exerts a large, positive impact on economic growth.” (MIT, 2001)

When financial markets are not doing well, interest rates on loans will increase and access to credit decreases. Interest rates are higher because of the risk that banks feel are involved. In times of high risk, interest rates go up. It is a way for banks to limit their losses and make as much money back – just in case a default occurs. So those businesses that are able to get credit are finding that it is more expensive than it used to be. Many companies need credit – loans – in order to sustain day to day operations. When the financial markets are in upheaval, and there is concern about lending, businesses have trouble getting the capital they need to keep running because banks are reluctant to lend to businesses, due to the fact that so many businesses, large and small, have failed. (Highland) This causes businesses to increase prices because operating costs are higher. In addition, in an effort to cut costs and avoid failure, businesses then begin to lay people off. As more people lose their jobs, consumers stop spending money. This means that they are not spending money at businesses. This not only affects business directly, due to fewer customers spending money, but it also affects the economy at large. As fewer people spend money to keep businesses going, more people have to be laid off. And then even fewer people spend money. It's a cycle that perpetuates itself. (The Impact of Financial Markets On Your Business)

Explain the role of the US Federal Reserve, the Federal Reserve Chairman, and Board, indicating its effectiveness in today’s economic environment. Provide support for rationale.

The US Federal Reserve is the central bank of the United States. It was established in 1913 by President Woodrow Wilson to provide the nation with a safer, more flexible, and more stable monetary and financial system. The current Federal Reserve Chairman is Ben Bernanke. The Fed's principal goal of economic stability has not changed since its creation. Over the past ten years, the Fed functions have expanded to take into account the extensive changes in financial institutions, payments processes and markets.

The Federal Reserve includes 12 regional Federal Reserve banks, each which oversees member banks in its region that provide banking services to depository institutions and to the federal government. (The Federal Reserve in the US Payment System, 2013) The primary purpose of the Federal Reserve is to regulate the United States banking system and maintain stability of the financial system. Part of the Fed’s responsibility involves setting monetary policy which means controlling the money supply of the United States in order to keep the US economy strong and growing.

The three tools of monetary policy that the Federal Reserve uses to control the money supply are: the required reserve ratio, the discount rate, and open market operations. (Tomlinson) Monetary policy helps the US maintain price stability, achieve maximum employment, and maintain moderate interest rates.

These goals and tools are still in place today and as a matter of fact, have expanded and grown in response to economic and financial issues. In 2008, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) of 2010. The Dodd-Frank Act established new responsibilities for the Fed, set new limits on financial firms’ allowable activities and created new agencies, such as the Consumer Financial Protection Bureau. Interpretation, rule-writing and implementation will take time. The Fed has kept interest rates very low now for quite some time which is helping keep the recession from being much worse. Unfortunately though unemployment is still high but improving slowly. Still, the Fed’s primary objectives remain as relevant to our daily lives today as they have ever been. (The Federal Reserve Today, 2012)

Explain how interest rates influence the US and global financial environment. Provide support for evaluation.

Changes in interest rates (the percentage of the loan amount that lenders charge to lend money) can have both positive and negative effects on the US and global financial markets. When the Fed changes the rate at which banks borrow money, this has a ripple effect across the entire.

Interest allows borrowers to spend money immediately, instead of waiting to save the money to make a purchase. The lower the interest rate, the more willing consumers and businesses are to borrow money. When paying less in interest, this gives more money to spend, which encourages an increase in spending throughout the economy. Conversely, higher interest rates mean that consumers don't have as much disposable income and must cut back on spending; therefore, banks make fewer loans. (How Interest Rates Affect The US Markets, 2011)

Interest rates and the value of the dollar are inter-related. So when the Fed changes interest rates, the value of the US dollar changes. Lowering interest rates lowers the value of the dollar since it is cheaper to borrow money, so more money winds up in circulation. Conversely, raising interest rates increases the value of the dollar since there are fewer dollars in circulation. In the international market today, the supply and demand for currencies and the resulting relative values of currencies affects the demand for imports and exports. With a strong dollar, we can buy another country’s currency more cheaply making the prices of the country’s products appear lower to us so the quantity demanded rises. This means that when the US has a strong dollar, we buy more imports from foreign countries. (Herman-Ellison, 2007)

Describe how exchange rates may impact a business’ decision to operate in foreign markets.

The exchange rate can affect a business’ decision to operate in foreign markets depending up the strength of their home currency and whether or not the business uses imported products or whether they export products. This is because the supply and demand for imports and exports is affected by the supply and demand generated by the strength or weakness of the currency. When a business in one country demands products from a business in another country, they must enter into another market first, to buy that nation’s currency. (Herman-Ellison, 2007) If the US currency is strong, we can buy another country’s currency more cheaply making the prices of the products appear lower so the quantity demanded rises. This means that when the US has a strong dollar, we can sell more products in foreign countries.