The Fed’s impact is apparent in the dollar circulating in our pockets, saving accounts, inflation rates, unemployment levels and majorly, the country’s economy. The Federal Reserve, or simply the Fed, as it is popularly known, is the central bank of the United States. Although citizens are aware of its presence, not many fathom how it plays a pivotal role towards the development of the US economy. One of the main reasons why the Federal Reserve was established in 1913 was to control the monetary policies of the nation.
The Focus of This Article
In this article, we are going to discuss the impact of the Federal Reserve on the economy in detail discussing the tools it applies and the reasons why its decisions are so crucial. In the case you are an upcoming economist or a small scale businessman trying to keep track of trending news headlines during economic downturns, this article can serve as a friendly guide.
What is the Federal Reserve?
Before we dive into major parts discussing the impact of the Federal Reserve on the economy, let’s first understand its functions and tasks.
As a measure to improve the banking and monetary system of the United States, a more secure and stable system was created on 1913 through the Federal Reserve Act. Now serving as the central bank of the country, the Federal Reserve System is in charge of implementing the monetary policy. In simpler terms, the Fed aims to maintain controllable inflation while keeping the employment rate even higher and the interest rate lower.
While the Federal Reserve maintains a relationship with the government through the Treasury Department and other representatives, it functions separately from the government. Guided by a Board of Governors which consists of seven presidential appointees and Senate confirmates, the Fed is under the supervision of the open market committee. This committee, along with other regional bank presidents, holds the power to decide policies related to monetary aspects.
Federal Reserve Tasks
The first area to look into in order to see how to the Fed impacts parts like the economy is defining its functions:
- Managing Economic Policy
Along with the other policies made, the Federal Reserve is known for its monetary policy, which helps achieve stable prices and full employment through the regulation of money supply and interest rates.
Types of Monetary Policy
There are two major types of policies:
- Expansionary Policy: This policy is used to increase economic activity, mostly during a period of recession or when there are high levels of unemployment. In such circumstances, the Fed will lower the interest rates while increasing the money supply in circulation. This encourages spending, borrowing and investment by people and businesses.
- Contractionary Policy: This is used when the economy is growing too fast. The Fed may use contractionary policy to keep the economy from overheating and prevent inflation from getting too high. This policy will increase the rate of interest while reducing the money supply in circulation to cool off the economy.
Regulation of Financial Institutions
The Fed also has the important responsibility of regulating and supervising the other banks and financial institutions. The purpose of these actions is to protect the safety and soundness of the U.S financial system. The Fed imposes reserve requirements (the fraction of deposit money that each bank must hold as reserves) and conducts stress tests to estimate bank performance under adverse economic conditions. Also, the Fed puts in place rules aimed at eliminating reckless activities which could lead to another financial crisis.
- Last Resort: The Bank’s Role
During a financial emergency or a crisis, the Federal Reserve is referred to as the “lender of last resort.” This indicates that Fed steps in to provide emergency loans when commercial banks or others face liquidity issues. During these times, if these financial institutions are unable to obtain funding from other channels, the Fed steps in to rescue them. This function aids in sustaining faith in the banking system and stave off panic or a bank run.
- Services and the Payment System
The Federal Reserve provides certain services to banks, credit unions and even the U.S government thereby augmenting their role in the United States payment system. Such services include executing wire transfers, checking the clearing of checks, and supplying cash to these financial institutions. The Fed acts as a custodian of effortless money circulation within the economy thus sustaining business activities and consumer expenditure.
Tools the Federal Reserve Uses to Influence the Economy
After learning The Federal Reserve System’s primary functions, let us examine the specific tools it employs to influence the economy:
- Open Market Operations (OMOs)
Open Market Operations are considered as the most important Omnibus tool used by the Federal Reserves. This involves purchasing and selling government securities (Treasury Bonds for instance) at a set price in the open financial market. These are meant to change the short-term supply of money and interest.
Purchasing Securities:
When the Federal Reserve buys securities, there is an injection of money into the banking structure. As a result, the interest rates are lowered and the money supply increases. This leads to a boost in economic activity.
Selling Securities:
Selling of securities removes money from the system which in return lowers the money supply and raises the rate of interest. In return, an overheated economy can be slowed down along with “Inflation”.
- The Federal Funds Rate
Federal Reserve has direct effect on the Federal Funds Rate which is the price or the interest that Bank A charges on Bank B for a one day service of lending money. The funds rate is a breakfast price which has a knock-on effect on dozens of other prices in the economy. For example, it influences the grade of mortgages, car loans, and business loans.
Altering The Federal Funds Rate:
Lowering the Federal Funds Rate:
The fed encourages spending and increasing the money supply by lowering the interest rate. A lower rate of interest allows businesses to spend more money on new projects and consumers are able to make purchases on credit.
Raising the Federal Funds Rate:
Higher federal funds rate limits spending and borrowing because interest rate is higher so taking loans would be more expensive. This is often used to control inflation when there is an increase in the inflationary rate in the economy.
Reserve Requirements:
Reserve requirements is the set percentage of deposits that is required to be kept in the bank’s vault or in the central bank. To regulate the lending capabilities of most banks, the Fed can make changes to this requirement.
Lowering Reserve Requirements:
Bank lending increases when the Fed reduces the reserve limit because banks have more capital that can be issued as loans, positively impacting the economy.
Raising Reserve Requirements: Increased lending restrictions by the Fed raises the minimum threshold of published documents required to be released, causing a slowdown in economic activity.
Discount Rate:
The interest the Fed charges commercial banks to borrow money is called the discount rate. The spending and investing behavior of banks is influenced by any fluctuations made to this rate.
Discount Rate Lowering:
Having a lower discount rate will make it easier for banks to borrow money from the Fed, this may increase the money supply and stimulate economic activity.
Discount Rate Increasing:
A higher discount rate will make it more expensive to borrow from the Fed which may help in slowing down economic activity.
- Quantitative Easing (QE)
In periods of very high economic distress, the Federal Reserve may resort to another unconventional monetary policy known as Quantitative easing. This consists of the Fed buying huge amounts of longer-term government bonds and other securities to increase the money supply and reduce the long term interest rates. It may be needed to aid economic growth when conventional measures such as reducing the value of the federal funds rate no longer work, such as when rates are almost zero.
The Federal Reserve Policies on Inflation and Unemployment Issues
The Federal Reserve tries to do its best toward achieving a balance between price stability and full employment. The Fed’s dual mandate, however, restrains it from achieving inflation control. Attempting to achieve full employment without keeping inflation in check will ultimately lead to inflationary volatility. Price stability requires control over the money supply, which is usually not the case while aiming for maximum employment. Forexample, during times of economic recession the money supply is increased to encourage spending. Expended money leads to deflation, which means money loses its value thereby deepening the recession. Such attempts to increase full employment would inevitably throttle inflation.
Full employment without price stability can lead to recession. An economy can be characterized by an inflationary gap with high spending and robust protection but when spending exceeds the economy’s capacity to supply goods and services, it can be very detrimental. When an economy requires urgent help, the Fed needs to intervene with fiscal policies such as boosting the economy. This might be helpful for countries that easily control their money supplied without restrictions. These ‘supply’ economy countries will usually lead to recessions with inflated monetary supply.
To reverse these effects, the Fed tries to dampen the effects of recession with fixed expenses. Once a country’s economy starts cooling down after reaching an acceptable inflation rate or purchasing power, the economy starts purging hyper-surplus of money. on need or supply depending on prevailing market conditions through rationing credit and funds to control inflation, they will stop stimulating spending. Reducing the funding line will allow the economy to come back down without prompting the money spending strain exceeding pre-cooling barriers causing an inflation g. Cutting expenses directly wards collision temporarily suppresses the ability ration to control fund circulation, thus curbing spending overstuffed wallet markets.. Freer funds means making it easy to spend, which eventually slows down uniform measures. ”
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Why The Federal Reserve Decisions Actually Matters To You
The Fed can have a striking effect on people, companies, and the economy as a whole. Here is how:
- Influence On Loan & Mortgage Payment Rates
When the Fed lowers interest rates, it becomes more affordable to take out a loan. Moreover, home loans, auto loans and even credit cards may be easier for the consumers. In contrast, higher interest rates may increase the cost of loans and mortgages.
- Economic Growth & Employment Opportunities
With the monetary policies, the Fed can promote economic growth by lowering the cost of borrowing. This might encourage further investments and expansion of some businesses, leading to an increase in job opportunities and higher wages.
- The Movement Of Stock Markets
With regards to interest rates, the Fed’s decisions impact the stock market directly. Stocks tend to be more appealing to purchase when rates are low while bonds and savings accounts pay less. Higher rates tend to lower stock market returns as bond yields become more lucrative.
- Effects of inflation on Purchasing Power
Inflation has a direct impact on your purchasing power. The Fed raising rates to tackle inflation means that the prices of goods and services may increase, leading to lower purchasing power. Keeping inflation within limits ensures a reasonable standard of living is attainable.
Conclusion
The Federal Reserve is critical in the US economy by managing inflation, unemployment, and economic growth with an array of tools. Interest rates, the money supply, and any other monetary policy have implications on loan rates, stock market activity, and even the stability of our financial system.
The Federal Reserve’s impacts may seem insignificant, but their effects can be very significant. Understanding this influence helps you make more informed decisions concerning financial matters, such as optaining loans, and make better investments, saving, and spending.
All in all, the Federal Reserve’s activities go beyond Wall Street; even Main Street is affected. Focusing on these policies and activities can shed light on its economic impact and help determine how one positions themselves depending on whether we are heading to a financial boom or recession.