How the Fed Controls the Money Supply
The Federal Reserve Bank was created to oversee the economy. Its most important purpose today is to create and maintain a healthy economy by controlling the money supply. Basically, the Federal Reserve accomplishes this function through the following methods:
- Buying and selling U.S. Treasury Bonds. A committee named the Federal Open Market Committee (FOMC), which is made up of the board of governors and five of the Federal Reserve Bank's regional presidents, meets eight times a year to determine whether it needs to add to or take from the money circulating in the economy. How is this accomplished? It's accomplished through the buying or selling of U.S. Treasury Bonds. By buying these bonds, the Fed, as it's commonly referred to, adds to the money available in the economy by depositing money into banks when it purchases the bonds. This gives the banks more money to loan out. If the Fed determines that it needs to reduce the amount of money available, it sells bonds. This reduces the amount of money in the economy because individuals and businesses withdraw money from their bank accounts to buy the bonds and, as a result, banks have less cash to lend out.
- Adjusting the discount rate. The discount rate is the interest rate that financial institutions pay to borrow money from the Federal Reserve. This rate affects the economy because when the discount rate is high, banks make fewer loans because it costs them more to borrow money to use for these loans. When the discount rate is lower, banks make more loans because they don't have to pay as much to borrow the money from the Federal Reserve.
- Reserve requirements. The Fed uses reserve requirements to increase or decrease the interest rate for borrowing money. Let's examine how this works. All financial institutions are required to keep a specific amount of money on reserve with the Fed. How much depends on the type of institution and its size. Funds over the reserve amount are available for loans to businesses and consumers. The Fed tracks these reserve requirements on a daily basis. When the Fed wants to increase growth in a sluggish economy, it lowers its reserve requirements, which in turn lowers the interest rates for borrowing money. Banks have more money to lend to businesses and consumers, at lower interest rates, which can stimulate the economy. More businesses are started and jobs are created, and possibly a recession can be avoided. In the opposite situation, if the economy is booming, the Fed can increase the interest rate for loans to businesses and consumers by raising its reserve requirements. An increase in reserve requirements means banks have less money to loan and, therefore, the cost of borrowing goes up.
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Example
The Federal Reserve decreased interest rates several times during 2001 in an attempt to steer the economy in a growth direction and away from a recession. In 1999 and in 2000, the Federal Reserve increased interest rates three times each year during the economic boom.
More recently, in an effort to stimulate a seriously sagging economy, the Fed has held interest rates at historic lows as the government tries to provide economic stimulus to grow the economy and reduce unemployment.
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Many economists and business leaders feel that the Fed has abused its discretion in recent times by adjusting interest rates much more frequently than it did in the past. Reasons for this point of view are that rate changes are seen as quick, artificial fixes for the economy that cause inflation, and that consumers, businesses and investors come to rely on this strategy rather than acting in ways that promote long-term prosperity.
Other economic experts feel that the Federal Reserve is doing precisely the job it is supposed to do by raising and lowering interest rates as necessary to stimulate or slow down the economy.
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