The Federal Reserve System
- Article photo, courtesy of CEPR
The Federal Reserve System, commonly known as the "Fed," serves as the central monetary authority in the United States, akin to the Bank of England or the Bank of France in their respective nations. Its fundamental purpose is to implement monetary policy that supports the country’s economic stability and growth. But how exactly does the Fed influence the economy, particularly in determining interest rates? Let’s explore the structure, functions, and tools of the Federal Reserve, and how they all work together to manage the nation's financial system.
Structure and Functions of the Federal Reserve System
The Federal Reserve System is composed of 12 district banks overseen by the Board of Governors, an entity whose members are appointed by the U.S. President and confirmed by the Senate. These members serve 14-year terms, while the chairman serves a renewable four-year term. The Federal Reserve’s responsibilities include handling check clearing, issuing money, and acting as the "banker's bank." Membership in the system is mandatory for nationally chartered banks, and optional for state-chartered banks. However, national banks hold the largest share of U.S. banking assets.
Within the Fed, the Federal Open Market Committee (FOMC) plays a pivotal role in policy-making. It oversees open market operations, which involve buying and selling government securities, thus influencing the availability and cost of credit. These operations are the primary means by which the Fed controls the money supply, impacting broader economic variables such as interest rates.
Money Supply and Its Impact on Interest Rates
Money supply, a key focus of the Fed's activities, is the total amount of money available in the economy, which includes various forms such as cash and demand deposits. Market participants pay close attention to this supply because, as the liquidity preference theory suggests, the interaction between supply and demand for money determines interest rates. The demand for money is influenced by investment opportunities, while the supply is largely controlled by the Fed.
There are multiple definitions of money supply. The most basic, M1, includes cash in circulation and other readily accessible deposits. A broader measure, M2, includes everything in M1 plus savings deposits, time deposits, and money market funds. The Fed’s control over these aggregates influences interest rates, which in turn affect borrowing, investing, and overall economic activity.
Policy Tools and the Chain Reaction
The Fed cannot directly control complex economic outcomes like prices, unemployment, or exchange rates. Instead, it uses a chain reaction of policy tools to influence what are known as operating targets—financial variables such as interest rates that, when adjusted, indirectly affect intermediate targets like inflation or output. For example, the federal funds rate, an overnight interest rate charged between banks for reserve loans, is a crucial operating target. The Fed influences this rate through three primary tools:
- Open Market Operations: The buying and selling of government securities. When the Fed buys securities, it increases reserves in the banking system, which lowers interest rates. Selling securities has the opposite effect.
- Discount Rate: The interest rate charged on loans made by the Federal Reserve to banks through the "discount window." A higher discount rate discourages borrowing, thus reducing the money supply and increasing interest rates.
- Reserve Requirements: This refers to the minimum reserves that banks must hold. Lowering reserve requirements frees up more money for loans, expanding the money supply and lowering interest rates, while raising the ratio does the reverse.
The Balancing Act: Managing Inflation and Economic Growth
One of the Fed’s central objectives is price stability, which is crucial for ensuring households and businesses can make financial decisions without fear of volatile price changes. By influencing interest rates and controlling the money supply, the Fed attempts to foster low inflation while maintaining sustainable economic growth. However, monetary policy can be a delicate balancing act. Expansionary policies, while aiming to reduce unemployment, may lead to inflation without any long-term benefits to employment or output.
In short, the Federal Reserve’s role in managing the U.S. economy is pivotal, with its influence over interest rates serving as a key lever in maintaining financial stability. Through its policy tools and strategic decision-making, the Fed works to ensure that economic growth is sustainable, inflation remains in check, and the country’s financial system operates smoothly.
