America’s Federal Reserve System How it Works and What it Does

If you’ve ever watched the bozos at CNBC, then you’ve no doubt heard multiple references to the Federal Reserve System. But do you really know what the Federal Reserve System is and why it exists and how it affects your life? The Federal Reserve System was created by the US Congress under the Federal Reserve Act in 1913 in order to establish a more solid foundation for the economic policies of the country that would potentially forestall the kinds of monetary crises that had afflicted America during the preceding decades. The concept behind the creation of the Federal Reserve was to establish an agency that would set and maintain monetary policy in the US by influencing monetary conditions.

Responsibility for establishing monetary policy is in the hands of the Federal Open Market Committee (FOMC). The FOMC is made up of the seven Federal Reserve Board members along with five of the twelve Federal Reserve Bank chairmen. It is the job of the FOMC to meet throughout the year-usually no more than eight times-to analyze the current state of the US economy and prepare monetary policies in response.

Although a variety of methods for controlling monetary policy is available, the Federal Reserve typically engages in open-market operations. Should the Fed’s analysis of economic conditions lead them to the conclude that money supply should be increased, it would then move to purchase US Treasuries securities from the public. Just as the purchase of securities by an individual would raise his assets accordingly, so is this true for the Federal Reserve. For instance, if the Fed bought a billion dollars worth of treasuries, its assets would be raised by a billion. To pay for this purchase, the Fed simply issues a check on the Federal Reserve itself and the result is a billion dollar increase in the money supply of the country. The effect of more money in the nation’s supply leads to lower interest rates and lower interest rates generally results in an increase in loans and borrowing, as well as more money being spent. Since consumption is a primary component in determining the Gross Domestic Product (GDP), the GDP also tends to increase as a result of this move. Although increasing the money supply is directed toward spurring growth in the economy through increasing employment and wages, this can’t be sustained over the long term due to inflationary pressures.

Alternatively, if the Federal Reserve felt that a reduction in the country’s money supply was necessary it would reverse the operation and sell a billion dollars worth of Treasury securities to the public. The sold securities would result in a net loss of one billion in assets, but the checks received in exchange would be used to eliminate an equal amount in deposits at banking institutions. Therefore, the monetary base of the country will be reduced by one billion dollars. This reduction in the money supply causes interest rates to rise and borrowing levels to drop. The result here is the opposite to that of increasing money supply; inflationary pressures are more easily contained but at the cost of potentially slowing the economy and increasing unemployment rates. Even the mere appearance that the Fed may take this route may lead to fears of encroaching inflation among workers who will seek to offset the effects by requesting a wage hike. An increase in wages can then in turn create the inflation that workers feared in the first place.

Although open-market operations are the primary method the Fed uses to control the money supply, it is not the only way; the Fed also utilizes changes in reserve requirements and discount window lending. A minimum for each type of deposit banks hold as reserves is set by the Federal Reserve and changes in these minimums affect the reserve-deposit ratio. Any increase in reserve requirements increases the reserve-deposit ratio which in turn reduces the money multiplier. This results in a reduction in the money supply of the monetary base. Since changing reserve requirements affects long-term planning this method is used on as a last resort.

The rate that the Fed charges banks for short-term loans is called the discount rate and the process of the Fed lending reserves to banks is called discount window lending. If an increase in borrowing from the discount window is made, the monetary base will also rise; any decrease in discount window borrowing creates a reduction in the monetary base.

The discount rate is the basis on which real interest rates are predicated and real interest rates are manipulated by the Fed to influence economic decisions. The figures at which long term interest rates are set will influence long term decisions by businesses regarding such things as expansion and investment. It will also affect both the desire and ability for individuals to try to get long term housing loans. When interest rates are lower families typically invest more in durable goods because of the availability of more money. Lower real estate rates also have the effect-when other aspects of the economy are going well-of increasing the desire of banks to extend loans. Consumers who have gotten a loan may therefore have more money to spend which strengthens the economy.

Since the Federal Reserve clearly cannot control both unemployment and inflation at the same time, the problem therefore is how best to find a middle ground in which the economy can continue strong growth without giving in to inflationary pressures. None of the policies available to the Federal Reserve can do this, nor is there any guarantee that any specific move by the Fed will result in the desire effect. The problem stems partly from the fact that there is always a lag between the decision that the Fed ultimately makes and partly from the fact that there are so many macroeconomic factors at play. Economic conditions can turn on a dime-witness the unexpected and devastating effects as a result of Hurricane Katrina-and there is no equitable method for the Federal Reserve to react to such factors as quickly. The Fed, therefore, must consider policy based only on what is known, what has occurred historically, and algorithmic models and potential possibilities. The best method of keeping inflation in check with acceptable unemployment and overall economic growth is a topic of much debate. Many economic theories have posited advantages and disadvantages to current monetary policies that are in complete opposition to each. Obviously employment should be a high priority in a consumer-driven economy such as America’s so it remains all-important to make decisions that will spur new jobs and wage growth.

There is no single policy that can ensure while keeping inflation at bay, but since inflation is often the result of consumer expectation, probably the best way to influence the possibility of inflationary pressure is to shape a policy in which monetary movement from the Fed is telegraphed with a stronger sense of credibility. The best way to achieve this would be to create standards for inflation targets. All too often the private sector responds to fears that the Fed is controlling the money supply to stave off inflation and reacts with higher wages, creating a self-fulfilling prophecy of sorts.