The Federal Reserve (often called Fed) is the central bank of the U.S.A. responsible for the american currency: the U.S. dollar. Its goals can be summarized in three points:
– guarantee the stability of prices and currency.
– reach full employment.
– help economic growth.
To achieve these goals the Fed can use both monetary policy and bank regulations.
A vital role of the Fed is to target the so-called Federal fund rate. It is the interest that banks charge each other (bank to bank) for day-to-day loans of extra reserves. The value of this rate is of primary importance because it directly influences the interest rates that banks charge to borrowers. An important point here is that the Fed cannot directly set this rate, but can influence it using certain mechanisms:
1. Set the reserve ratio.
2. Adjust the discount rate.
3. Do open market operations.
We shall now explore these tools in detail.
1. Setting the reserve ratio:
If you refer to our first article (« What is finance? »), you may remember that our banking system is based on fractional reserve. That is to say, for each deposit that a bank receives, it must keep a certain amount of reserve and can lend the remaining. This fractional reserve system is what produces the multiplier effect of the money and the difference between M0 and M1 (refer to the first article). So the Fed is responsible for setting the amount of reserve ratio. Thus, a more restrictive reserve ratio implies less money in circulation, whereas the exact contrary appears when the reserve ratio becomes less restrictive.
2. Adjusting the discout rate:
The banks can borrow money daily from the Fed to cover its legal reserves. We call discount rate the interest rate that the Fed charges the banks. The effect of reducing this rate is an increase in the reserve of the banks (they borrow more money from the Fed) which implies an increase in money supply.
3. Doing Open Market Operations:
The Fed can operate on open markets too. Indeed, it buys and sells governement securities such as bonds and T-bills. The effect being that when it purchases securities, it increases money supply and thus reduces the interest rates; whereas when it sells securities the effect is the exact opposite: money supply decreases and thus interest rates increase.
One of the main issues that the Fed has to deal with is inflation. Inflation occurs when the monetary system grows faster than the economic system. You may have heard that the Fed (or another foreign central bank) has led some operations to deal with inflation.
We are now able to understand how the Fed can act when inflation threatens our economy. When inflation occurs, there is a necessity in reducing the total money in circulation to counteract it. Thus the Fed strategy is to aim for a higher fund interest rate. The expected effect being that all the interest rates increase, there will be less money lent and thus less money in circulation. So in the light of what we have seen, the Fed can act on three levels. It can increase the reserve ratio and/or the discount rate or do open market operation by purchasing governement securites.
The Fed thus plays a major role in the whole economic and financial system in the U.S. and in the world (as the dollar is the world’s reserve currency). Its strategy has sound effects and requires anticipation of the future money supply and inflation.
introductory picture from: morguefile