Overview
Purpose:
To show how the responsibilities and powers of the Federal Reserve have been broadened over the years; and indicate how the Fed can control the money supply and influence the level of interest rates and inflation.
Objectives:
1. One of the most important functions of the Federal Reserve System is to ensure that the amount of money in the U.S. economy is consistent with non-inflationary growth.
2. The Fed controls the amount of money in the economy by controlling the reserves in the banking system. This is done in three ways:
a) Most often the Fed injects or removes bank reserves by buying or selling government bondsæopen market operations.
b) The Fed can also encourage or discourage bankers in their attempts to borrow reserves by lowering or raising the discount rate, which is the interest rate the Fed charges for its loans to banks.
c) The Fed can change the required reserve ratio or the percentage of deposits that a bank must keep in its vaults as reserves.
3. If the rate of growth of the money supply is slowed, interest rates will initially rise and both economic activity and inflation will tend to slow down. The Fed cannot control how much the reduction in the growth of the money supply will affect economic activity, and how much it will affect inflation.
| Key Economic Concepts Federal Reserve System, required reserve ratio, discount rate, open-market operations, money supply. |
| Contemporary Issues After the terrorist attacks of Tuesday, September 11, 2001, U.S. financial markets were closed until the subsequent Monday – in part, because the massive damage to the Wall Street area. Right before the markets re-opened, the Fed cut interest rates by 50 basis points (half a percentage point). What kind of a signal was the Fed trying to send with such a dramatic interest rate cut? In the event, the markets fell precipitously for a few days and then began to recover. Did the Fed’s move help or hurt? |
|
