Federal Reserve Essay, Research Paper

In order to advance economically, the government of any region must make efforts to create forms of buying power. There are various ways in which this situation could be approached. In the United States, one of the most powerful institutions with the ability to do this is the Federal Reserve System. The Fed is responsible for enforcing many of the federal laws that protect consumers in their dealings with state-chartered banks that are members of the Federal Reserve System. It also assumes the role of being responsible for the United States’ Monetary System, which actually influences the growth of money and credit in the U.S. economy.

Since its establishment by an act of Congress in 1913, the Fed s primary role has been to foster a sound monetary and financial system and a healthy economy. To advance this goal, each branch of the Federal Reserve helps formulate monetary policy, supervises and regulates banks and bank and financial holding companies, helps maintain the stability of the financial system, and provides financial services to banks and other depository institutions and the federal government. To carry out its primary functions, the Federal Reserve needs information about the economy. The Board of Governors and each of the twelve regional Reserve Banks maintain staffs of economists and analysts whose research helps inform the decisions that go into monetary policy making, supervising and regulating banks, and serving and maintaining the stability of the financial system. Staff research focuses on every aspect of the economy, from the local to the international level. At the Atlanta Fed, for instance, studies may range from analyzing the makeup of rural banking markets in the Southeast to designing and testing economic forecasting models used in policy making.

The Federal Reserve supervises and regulates bank and financial holding companies, state-chartered banks that are members of the Federal Reserve System, foreign activities of all U.S. banks, and U.S. activities of foreign banks. As a supervisor, the Fed monitors, inspects, and examines banking organizations to determine their condition and to make sure they comply with current laws and regulations. As a regulator, the Fed creates and issues regulations and guidelines that govern banks structure and conduct. These regulatory standards are designed to ensure that banks operate according to safe and sound banking principles and meet the needs of their communities.

The Federal Reserve System established Community Affairs offices at each Federal Reserve Bank and the Board of Governors in 1981. This was done, as a method of specialization in that these offices would be able to determine what needs should be met for specific areas of the country. These offices work with banks, bank and financial holding companies, nonprofit and for-profit development organizations, and local governments to identify a particular community s credit needs and ways to address those needs. The primary goal of the Fed s Community Affairs program is to promote effective community development lending, investment programs, and fair lending.

In order to make buying power available, the government must consider a major factor: inflation. When the supply of money grows too rapidly in relation to the economy’s ability to produce goods and services, inflation may result. It is a case of too many dollars in the hands of buyers chasing the same amount of goods. On the other hand, too little growth in the money supply can lead to such problems as recession and unemployment. As the money flow slows down, people have fewer dollars to spend for various goods and services. Businesses, in turn, receive less money for the goods and services they produce and have less to spend for the resources they use.

Through monetary policy, the Federal Reserve tries to avoid either of these extremes. To do so, the Fed analyzes the national economy and seeks to influence growth in money and credit that will contribute to stable prices, high employment, and growth in the economy. The Federal Government can put more money in the economy, by buying U.S. government securities on the open market. The Fed pays sellers for the securities. They, in turn, deposit the money in various financial institutions. While these financial institutions are required by law to keep a certain percentage of this money on reserve, they are free to loan out the remainder.

For example, suppose Kate Smith is holding a U.S. Treasury bond, one she can sell at any time. Through a broker, she sells this bond to the Federal Reserve for $1,000. At this point the Fed, using power granted to it by the U.S. Congress, pays Ms. Smith by creating $1,000 that did not exist before. If we were to write a check for $1,000, that money would come out of our bank account. But the Fed’s check creates new money by adding to banking reserves. Ms. Smith deposits the $1,000 in Trustworthy Bank. Trustworthy must keep a certain amount on reserve. We’ll suppose the bank’s reserve requirement is 10 percent. Of the $1,000 deposit, then, Trustworthy can loan out $900, known as its excess reserves. Bill Jones, an insurance salesman, needs to borrow $900 for new computer equipment for his office. Trustworthy Bank credits Jones’ bank account with $900, money he will later repay. In turn, Jones writes a check to Computerwise Co. for $900. This company, in turn, deposits the check in Reliable Savings and Loan. Reliable must hold back 10 percent on reserve and can loan out $810. This process goes on and on, increasing the amount of money in the economy. While each financial institution can only lend an amount equal to its excess reserves, the financial system as a whole can expand the amount of money in the economy.

Money is created in the United States economy in two ways that are different but related. The Federal Reserve begins the process by creating “raw money” when it buys a Treasury security on the open market. The banking system can then expand this amount of money by lending it. On the other hand, if the Federal Reserve sees the nation is threatened with inflation, it may sell some of the securities in its portfolio. Buyers pay the Federal Reserve for these securities out of their bank accounts. At this point, places like Trustworthy Bank and Reliable Savings and Loan have less money to lend. In this way, the Federal Reserve removes money from the economy since the money paid to the Fed does not go back into any sort of bank account.

A second way in which the Federal Reserve can influence the economy is by raising or lowering the discount rate; the interest rate charged financial institutions when they borrow reserves from the Fed. Although seldom used, discount rate changes can be powerful signals of the direction of monetary policy. The Federal Reserve can also have a powerful impact on the flow of money and credit by either raising or lowering reserve requirements, the percentage of their deposits that financial institutions must keep on reserve. If the Fed lowers reserve requirements, this can lead to more money being injected into the economy since it frees up funds that were previously set aside. On the other hand, if the Fed raises reserve requirements, it reduces the amount of money that institutions are free to loan out or invest. However, the Fed is cautious about changing reserve requirements and has done so only occasionally because of the dramatic impact it can have on both financial institutions and the economy.

For example, if the government were to raise the reserve requirements from 10% of each deposit to 25% of each deposit, the aforementioned hypothesis would be invalid. If Ms. Smith deposited her bond after the requirement increase, it would be necessary for the bank to retain $250 of that $1,000. Ergo, only $750 would be available for loan. Because of this Mr. Jones would be unable to take out the necessary loan of $900, and would therefore be unable to purchase said computer equipment. As the chain of events continues, Computerwise Co. would have no potential sale, and would not deposit any money into Reliable Savings and Loan. Obviously, this cuts back the amount of money available for circulation, as less currency would be available for loans and deposits.

By the same token, had the reserve requirement been lowered to 5%, the aforementioned hypothesis would be invalid again but to a different degree. In this scenario, when Ms. Smith deposited her $1,000 bond the bank would only be required to retain $50. Therefore, $950 would be available for loan, and it would be possible for Mr. Jones to take out a more expensive loan to obtain higher quality equipment. Computerwise Co. would then make a larger profit, and after depositing it in Reliable Savings and Loan, more money would be available for circulation of currency to other loans and/or investments.

Which method is more effective? That all depends on the condition of the economy, and whether or not the Federal Reserve looking to make a mild or drastic change in the creation and circulation of buying power. Clearly, buying government securities in the open market is a simple, yet effective method of distributing buying power. The amount of money can be determined by the worth of bonds and the quantity by which they are distributed. Because most bonds require a certain amount of time to elapse before they can retain their full value, this method of creating buying power is more gradual, and would most likely be used by a stable economy that does not require immediate and drastic changes.

Altering reserve requirements would have a much more drastic and direct effect on the availability of buying power. By examining the aforementioned hypothetical situation, one could observe that the effects of an alteration would take place immediately. However, it is very easy to control how much buying power is available because of the concrete use of percentages. With hard numbers and facts that can come immediately through statistics after an alteration, it would be a clear way to make a judgment on the appropriate direction for the economy to travel in. It appears obvious, though, that the economy would not survive solely on this method. It is too extreme and would require immense amounts of research. By changing a system too often, it becomes unstable. This would absolutely put a damper on the economy.

It is blatant that the importance of the Federal Reserve System is great. Without it the United States would not be the economic superpower that it is today. The country’s methods of creating and distributing buying power have proven to be quite successful, as the economy has been booming for years. By using simple methods that allow the economy to almost naturally stimulate itself, there is less chance of a negative outside interference, which would explain the long-term prosperity that the nation has experienced.