The Federal Reserve is the nation’s central bank. Basically it is the banks’ bank – it lends money to banks. The current chairman is Ben Bernanke.
The Goals of the Fed (Monetary Policy):
The Fed influences the amount of money in circulation in the economy in order to promote economic growth and job creation, but they have to balance this against price stability (controlling inflation). More money circulating in the economy will lead to growth, but could cause inflation. Less money circulating with keep inflation down but will also limit growth.
Tools of Monetary Policy
1. Open Market Operations
Buying/selling government securities (mostly bonds) to banks
When the Fed sells bonds, it keeps the cash, shrinking the money supply
When it buys bonds, more cash is available to the banks to lend, which increases economic activity
2. Reserve Requirements (Fractional Reserves)
How much banks can lend/invest vs. how much they have to keep in reserve
Higher reserves = less cash in circulation
Lower reserves = more cash in circulation
3. Discount Rate
Short term interest rates for banks (borrowing from Fed).
This influences the interest rate banks charge customers, which affects the cash in circulation.
A high rate will discourage borrowing and limit the cash in circulation. A low rate will increase borrowing and growth
Basically…
It’s a balancing act!
· A loose money supply (easy availability of money) leads to economic growth but also leads to inflation
· A tight money supply keeps inflation down but slows growth