By serving as an intermediary bank, setting reserve requirements, and making short-term loans to banks, the Fed plays a crucial role in overseeing the nation’s banks and money supply. Our checks (a huge part of our money supply) are efficiently processed, banks are prevented from lending more of our money than is safe, and banks are provided assistance in meeting the federal regulations that ensure a stable and safe financial system. But the Fed also uses some of these same tools to more generally influence the performance of the economy. By adjusting the discount rate and reserve requirement, the Fed can make adjustments in the nation’s money supply during periods of recession and inflation.
Known as monetary policy, the Fed’s approach to economic problems is based on a relatively simple calculation: most economic problems are caused by having either too little or too much money in circulation.
During periods of recession, the Fed tries to stimulate growth by lowering the discount rate. This, in turn, leads banks to lower the interest rates they charge their customers. And since people are more willing to make a major purchase when they can borrow money at 5%, rather than 7%, individuals are encouraged to borrow and spend more, and businesses are encouraged to invest and expand. The Fed can also put more money into circulation by lowering the reserve requirement. This enables banks to keep less in reserve and lend out more money to consumers and investors. Finally, the Fed can inject money by buying bonds in the bond market—through these “open market operations” the Fed uses Federal Reserve funds to buy up government securities.
These recession-fighting strategies are referred to as loose money policies. If on the other hand, the Fed pursues the opposite course of action because it fears inflation—in other words, if it raises interest rates and reserve requirements, and sells bonds—we say that the Fed has adopted tight money policies.
Monetary Policy Options
To Fight Recession:
To Fight Inflation:
Since its creation in 1913, the Fed has grown into the most powerful and crucial financial institution within the American economy. It monitors America’s money supply and the banks that both house and create Americans’ money. The Chairman of the Fed is arguably the most powerful economic figure in the country—many argue that the Fed Chairman can have a greater impact on economic conditions than the president of the United States.
Do you think you are up to this responsibility? Try out our Money & Banking Game and see how you would handle the job.
Why It Matters Today
Take a look at this chart of the prime rate, as set by the Fed, over the past several years.
What stories does this chart tell?
What do you think happened in the late 1970s and early 1980s? Why did interest rates soar so high? Did the Fed's high-interest-rate monetary policy at the time succeed in its aims?
And what happened between late 2007 and 2009? Why would the Fed cut the prime rate so dramatically?
What do you think will happen to interest rates next?
“The Gambler’s” monetary policy is to know when to hold ‘em and when to fold ‘em.