Federal_Reserve

Federal Reserve The Federal Reserve Bank was established by the United States government in the 1930s to stop society from bank panics but its role has since grown to include managing the country’s money supply (Hubbard & O'Brien, 2010, p. 842). The role of money in society is crucial, which is why it is important to have an insittution overseeing it on a full-time basis. Paper money and coins exist because they are the most efficient way to purchase goods and services. Before money existed, goods and services were purchased through the barter system (trading one good for another), which is not efficient. For example, if all dentists were paid with chickens, they would have more chickens than they need, and would no longer offer dental services to their customers. Money has afforded people the opportunity to become highly specialized in a specific field because they can use money to buy all other goods and services they need (Hubbard & O'Brien, 2010, p. 827). Until the 1970s, money represented a promise that could be redeemed for a fixed amount of gold or silver. Now, this is no longer the case, but money is instead backed by the “full faith and credit” of the United States government. The Central Bank is responsible for printing money and setting interest rates in order to control the supply of money available to citizens. When there is too much money available (too much money chasing too few goods), then inflation occurs. When there is too little money available, then deflation occurs, and economic growth slows or becomes negative (i.e., a recession). The central bank is separate from the federal government so that the government does not attempt to use the bank for political reasons (Hubbard & O'Brien, 2010, p. 967). Another reason the bank remains separate is to ensure the government does not sell its bonds only to the bank and not to the public thus causing inflation to rise (Hubbard & O'Brien, 2010, p. 967). The current monetary policy focuses on the “target range for the federal funds rate of zero to 1/4 percent to promote economic recovery and price stability” (Board of Governors of the Federal Reserve System, 2010, p. 31). The Fed has lowered interest rates to near zero in order to promote economic growth and prevent deflation as a result of the financial crisis. It has also initiated a policy of "Quantitative Easing" because traditional monetary policies no longer work when interest rates are at zero (Blinder, 2010). When interest rates have reached zero the Fed is unable to reduce the rates any further. However, quantitative easing only can carry the economy and if maintained for an extended period of time can become detrimental to the economy. The Fed has started to end programs started under quantitative easing such as the closing of the special liquidity facilities, Term Auction Facility, Primary Dealer Credit Facility and the Term Securities Lending Facility (Board of Governors of the Federal Reserve System, 2010). How does the Federal Reserve’s control over interest rates effect the economy' First, it is important to note that the Federal Reserve changes nationwide interest rates only indirectly, because it lends money to the country’s banks at a certain rate of interest. Banks then lend money to their customers at an interest rate over and above the amount that the Federal Reserve charged the banks. Lower interest rates spur investments by business because they can take out loans at a lower interest rate and thus more cheaply buy new equipment or factories. Lower interest rates also promote consumption by individuals as there is less benefit to leaving money in your savings account if it is earning close to zero interest. Once business and consumers begin to spend, demand increases, jobs are created, and the economy recovers. Then the Federal Reserve tries to control inflation by raising interest rates, which has the opposite effects of reducing investment and consumption. References Blinder, A. S. (2010). Quantitative Easing: Entrance and Exit Strategie. Federal Reserve Bank of St. Louis Review,, 92(6), 465-479. Retrieved from http://Ebscohost Board of Governors of the Federal Reserve System. (2010, July 21). Monetary Policy Report to the Congress. Retrieved from http://www.federalreserve.gov/monetarypolicy/mpr_default.htm Hubbard, R., & O'Brien, A. (2010). Economics (3rd ed.). Boston, MA: Pearson Hall.