Federal Reserve'S Role In The Economy

The Federal Reserve's role in the economy can be expressed by any of the three following metaphors: the Fed as a mechanic, a warrior, or a fall guy. Interestingly enough, the Fed can be all three at same instance. It really depends on what is happening in the economy at the time, what the Fed's role is at the moment, and the observer's perspective. Let's take a closer look at each metaphor and the circumstances under which it applies.

A mechanic is someone that repairs and maintains machines. This section describes the Federal Reserve's (Fed) role as a mechanic who repairs and maintains the nation's economy "machine". Any auto mechanic will tell you that maintenance as well as major service is necessary to keep an automobile running smoothly and efficiently. There may still be unexpected breakdowns, but the repairs are usually less costly if regular maintenance is done. The same is true for our economy.

The Federal Reserve System consists of 12 Federal Reserve banks located across the nation. These banks act as central bankers for privately run banks within their region. They also supervise and regulate private banking institutions for the benefit of the economy.

In order to explain the Fed's role as "mechanic" we must understand the services (maintenance) routinely performed to keep the economy running smoothly. Policies of the Fed are determined by the seven-member board of Governors appointed by the President and confirmed by the Senate. The Federal Open Market Committee (FOMC) is a key division of the board that consists of all seven governors and 5 out of the 12 regional reserve bank's presidents. They make the decisions regarding monitory policy.

Conducting the nation's monetary policy is critical to ensuring a healthy and growing economy. The Fed has to watch the economy closely to ensure that the nation's money supply is balanced for the current economic climate. If there is too much money available, the economy grows too fast and inflation can occur. Without enough money flowing through the banking systems, the economy can grow too slow a recession can occur. The FOMC meets every 4-5 weeks during the year to review the performance of our economy (routine checkups). Monitory policy is then adjusted as needed.

Compare this to the 5000 mile checkup and oil change performed on your automobile. The mechanic goes over the auto to make sure everything is in tip top shape. If the brakes are showing too much wear, it's time to replace the pads and turn the rotors.

The Fed uses 3 policy mechanisms to manage the money supply:

* Reserve requirements

* Discount rates

* Open market operations

As a mechanic, part of the maintenance process is to ensure that private banks keep a fraction of their deposits in reserve. The Fed makes sure the required reserves are maintained on a daily basis. Reserves can be in the form of cash (stored in a vault) or in deposits held by the regional Fed Reserve bank. After the required reserves are tucked away, the balance of deposits in private banks can be used for loans. These loans accumulate interest which becomes profit for the banks. Most people use credits and debits in the form of drafts to do their banking business. This gives banks the ability to create money out of nothing by loaning credit to Bob from Peter and Paul's deposits as long as Peter or Paul can access their money as they desire. Most people do not withdraw all their funds in the way of cash which means the bank can move money around as needed. This makes the money multiply as consumers, banks, and depositors use the same funds in the way of credits and debits to make transactions.

When the economy is growing too fast, the Fed needs to reduce the amount of available money. One way they do this is to raise the bank's required reserve ratio. This leaves the banks with less money to lend which lowers the multiplier effect of loan transactions, thus, slowing the economy. If the economy is sluggish or not growing, the Fed can do the opposite and lower the bank's reserve requirement to raise their lending capacity. This type of maintenance helps to guide the economy in the right direction.

Another form of maintenance and repair is discounting (discount rates). Private banks usually keep their required reserves at the regional Fed bank in the form of reserve credits. Because these reserves sit idle and don't make money, the banks try to keep them at the absolute minimum. At times the reserves may dip below the required amount which forces the bank to borrow from another private bank or the regional Fed bank. If the private bank can borrow reserve credit from the Fed at a lower interest rate than they get for lending the money themselves, it makes sense to assume the costs and borrow the maximum to enable more lending capacity. The Fed can increase or reduce their discount rates to affect private banking decisions on how to manage their reserve accounts. If the bank borrows to maintain their required reserves, it gives them extra reserve funds to loan out, thus creating additional money to grow the economy. The opposite is true if the Fed increases their discount rates. Banks are not as likely to borrow reserve credit at higher rates and therefore have less lending capacity which slows the economy.

The final and most impacting form of maintenance and repair on the money supply is open market operations. The Fed uses open market operations to influence the flow of money into or out of banks. People have choices in what they do with their money. They can deposit the idle funds into bank accounts or they can buy government bonds which put the funds into the bond market. When the Fed wants to increase the flow of money into the banking systems, it can offer to buy bonds from the public at increased prices. This entices people to sell their bonds which results in funds that will be deposited into banks. If the Fed wants to decrease the flow of money to the banking system, it can offer to sell bonds at reduced prices which entice people to buy them using funds that were deposited in banks.

As we've seen, the Federal Reserve System must keep a watchful eye on the economy and provide maintenance and repairs often. When the monetary economic balance is achieved, the machine runs smooth and steady. Everyone wins! Proper mechanics are important to every machine. But being a mechanic is only a part of the job the Fed is asked to do.

When you think of the broad scope of the Federal Reserve's mission, you begin to understand the importance of the Fed to the US economy. Sure it protects individuals