How The Fed Works

How the Fed Works

by Lee Ann Obringer

Federal Reserve building, Washington, D.C.

One of the more mysterious areas of the economy is the role of the Fed. Formally known as the Federal Reserve, the Fed is the gatekeeper of the U.S. economy. It is the central bank of the United States -- it is the bank of banks and the bank of the U.S. government. The Fed regulates financial institutions, manages the nation's money and influences the economy. By raising and lowering interest rates, creating money and using a few other tricks, the Fed can either stimulate or slow down the economy. This manipulation helps maintain low inflation, high employment rates, and manufacturing output.

In this article, we'll visit the mystical world of the Fed and talk about terms like monetary policy, discount rates, and open market operation. We'll find out just what kinds of tasks fill Ben S. Bernanke's day, and see how his and the Federal Reserve Board's decisions affect our everyday lives. Related Content:

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* How Income Taxes Work

* How Banks Work

* How the Euro Works

* Opinions:

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Why do we need the Fed?

Sometimes, in order to understand why you need something, it helps to find out what it was like before that "something" was created. Before the Federal Reserve was created in 1913, there were over 30,000 different currencies floating around in the United States. Currency could be issued by almost anyone -- even drug stores issued their own notes. There were many problems that stemmed from this, including the fact that some currencies were worth more than others. Some currencies were backed by silver or gold, and others by government bonds. There were even times when banks didn't have enough money to honor withdrawals by customers. Imagine going to the bank to withdraw money from your savings account and being told you couldn't because they didn't have your money! Before the Fed was created, banks were collapsing and the economy swung wildly from one extreme to the next. The faith Americans had in the banking system was not very strong. This is why the Fed was created.

The Fed's original job was to organize, standardize and stabilize the monetary system in the United States. It had to set up a method that could create "liquidity" in the money supply -- in other words, make sure banks could honor withdrawals for customers. It also needed to come up with a way to create an "elastic currency," meaning it had to control inflation by making sure prices didn't climb too quickly, and it needed a way of increasing or decreasing the country's supply of currency in order to prevent inflation and recession. In the next two sections, we'll discuss these inflation and recession.

Inflation

Inflation is not a good thing because it slows down economic growth.

For example, when inflation is high, things cost more and people spend less. They also do less long-term planning that involves spending money, such as building houses and investing. Businesses are affected in the same ways. When inflation is high, it tends to fluctuate quite a bit. This uncertainty makes people wary of spending money for fear that inflation will increase even more and they won't be able to pay their bills.

High inflation also adds additional costs to long-term interest rates. These costs are to offset the risk associated with inflation. The additional costs make borrowing money less attractive. When people don't buy things (when demand is down), then the supply of goods gets too high, production has to decrease, and unemployment increases -- in other words, recession hits.

When prices are stable (when inflation is low), consumers make more purchases, investments, etc., production output is maintained and employment remains high.

Recession

When recession hits, the Fed can lower interest rates in order to encourage people to borrow money and make purchases. This works in the short run, but it has to be handled carefully so that inflation isn't impacted in the long run.

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The Fed has to carefully balance the short term goals of increasing output and employment with the long term goals of maintaining low inflation.

Fed Tasks

Maximum Employment

Maximum employment doesn't necessarily mean that everyone is working. Economists have a "natural rate" of unemployment that is ultimately the goal. If the unemployment rate is pushed too low -- below 5% or so -- inflation rises because more money is in the economy, and that goes against the long-term Fed goal of stable prices.

The Fed regulates financial institutions, acts as the U.S. government's bank, acts as a bank's bank, and is responsible for managing the nation's money. The Fed has two divisions: One group, the Board of Governors, is responsible for setting monetary policy and managing the nation's money; the other group, the 12 regional Reserve Banks, acts as the service division that carries out the policy and oversees financial institutions. The regional Reserve Banks represent the private sector. Both of these groups have the same goals.

In its role as money manager, the Fed has two primary goals:

* Maintain stable prices (control inflation)

* Ensure maximum employment and production output

It achieves these goals indirectly by raising or lowering short-term interest rates. Although these are two separate goals, the outcome of each is the same -- a stable economy. In the following sections, we'll discuss the goals and the way the Fed goes about achieving them.

Fed Tasks: Monetary Policy

Monetary