What is the Federal Reserve

by Investing School on March 4, 2009

Whenever there’s a financial crisis, the light is always shed on the Fed (formerly known as the Federal Reserve System or the Federal Reserve).  We always expect them to do something while we criticize their actions but few of us really know what they are and what they are supposed to provide.  This article is designed to give a brief summary of the Federal Reserve System.

Functions of the Federal Reserve System

Created in 1913, the Federal Reserve’s primary responsibility is to stabilize the financial system.  Some of the other functions include:

  • Balance the interests of banks and the central responsibility of the government (ie to lend to the public as opposed to make only the most profitable loans)
  • Act as a central bank for the United States
  • Regulate financial institutions
  • Change the monetary policy (interest rates) to manage United States’ money supply to a controllable and sustainable level
  • Addresses financial crisis and keep the stability of the overall system

Monetary Policy of the Fed

Of all it’s functions, the monetary policy is the most commonly talked about.  The main goal of this policy is to maximize employment, stable prices, promote economic growth and have moderate long term interest rates.

To do so, the fed basically sets a target for the federal funds rate and the discount rate.

Federal Funds Rate – The rate that the federal reserve would like to see interbank lending at for federal funds.  Since the interest rate is not determined by the fed but rather by the market, the Fed will change the money supply in the whole system in order to achieve the target rate.

Discount Rate – This is the rate that the Fed will charge for directly lending money to the banks.  Since the Federal Reserve wants to encourage banks to find other means of capital, these overnight loans (also known as the discount window) will have an interest rate that is usually 1% higher than the federal funds rate.

Since both of these rates affect the prime rate which is approximately 3% higher than the federal funds rate, the Fed indirectly affects economic growth.  (A higher interest rate of borrowing will slow down economic growth and also inflation while a low interest rate will increase the potential for inflation but stimulate borrowing and thus growth).

What this Means for Us

The Federal Reserve’s actions will have a significant impact on our borrowing power as consumers.  By learning about how the rates work, we can have a better gauge on how the prime rate will be affected and thus our ability to borrowing funds for our needs.

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