The Reason For Having the Federal Reserve

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The reason for having the Federal Reserve is to provide a mechanism to control the amount of money available in the economic system. Too much money in the system results in inflation. Too little money results in recession. If you imagine the economic system as one side of a seesaw, the Fed functions as the counterbalance on one side. If you interested what the federal reserve does you can read about it here.

What Is The Federal Reserve?

The Fed is a strange hybrid of private banks with federal authority, but not really under government control. It operates mostly out of sight, to keep the money flowing between the extremely rich, the financial markets, the banks, and the consumers, all the while responding to political pressures, both nationally and internationally. It holds its meetings in private, making decisions that affect the economic well-being of all of us.

Federal Reserve Interest Rates

Although the Fed has other tools it can use, the process that gets the most attention concerns interest rates for banks, particularly the commercial banks. It can be a bit misleading when news media announce the Fed’s decisions to change interest rates. These rate changes directly affect the commercial banks. They may or may not affect consumers.

How The Fed Controls The Money Supply With Interest Rates 

This is how the process is supposed to work. If the Fed decides that there is too much money in the system, it raises the interest rates the commercial banks pay to borrow money. If it decides there is not enough money in the economic system, it lowers the interest rates.

How The Federal Reserve Increases The Money Supply By Reducing Interest Rates 

The interest rates the Fed charges commercial banks directly affect how much money other banks throughout the economic system can create. Let’s use round numbers and say that the Fed wants to increase the amount of money in the system. It lowers the interest rate so that it is cheaper for the commercial banks to borrow money. The Fed then loans a billion dollars to commercial banks at a lower interest rate.

The Commercial Banks Loan To Other Banks

The commercial banks now have more money available to loan to other banks, so they loan the billion dollars from the Fed to “thrifts,” which are the savings banks, savings and loan banks, corporate banks, and credit unions. By loaning the billion dollars to other banks, the commercial banks create five billion dollars out of the billion the Fed loaned to them. The thrifts then take those five billion dollars and make loans, creating who knows how many more billion dollars, which circulate in the economic system. This process creates more money in the system.

How The Fed Decreases The Money Supply By Raising The Interest Rate

If the Fed wants to decrease the amount of money available, the process works in reverse. It raises the interest rate to make it more expensive for the commercial banks to borrow money, which reduces the amount of money that the commercial banks loan to the thrifts, which reduces the amount of money available for consumers to borrow.  

How The Banking System Is Supposed To Work

This is how the banking system is supposed to work. The reason for having the Federal Reserve is to provide the balancing mechanism to keep prevent both inflation and recession by controlling the flow of money. The current financial crisis is evidence that the system doesn’t work as well as it is supposed to work.

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