by Aristotle Bournazos
Lately we have been hearing about the Federal Reserve and inflation. Inflation is the rise in cost of goods and services. We have seen all around us that the price of things we use every day have gone up in price very quickly. What is the Federal Reserve and what can it do to help stop inflation? The Federal Reserve or Fed as it is called, is the central bank of the United States which determines how much money is floating around in the economy to be spent on goods and services. Its goal is to keep unemployment and inflation in check. It does this through controlling the money supply. There are three ways the Fed can do this: (1) reserve requirements, (2) the discount rate and (3) open market operations.
RESERVE REQUIREMENTS
The reserve requirements are set by the Fed. The way this works is that banks take in deposits. From these deposits they are required to keep a certain percentage on hand. This is called the reserve requirement. They then invest some, lend some out as car loans, mortgages, personal loans etc. The banks pay a depositor interest on the deposit at one rate and loan the money out at a higher rate. The difference is the bank's profit. The Fed can manipulate the money supply by raising or lowering the reserve requirement. If the reserve requirement is raised the banks will have to keep more money on hand. This will lead to less money available to be lent out, higher interest rates and thus less money floating around the economy to be spent on goods and services.
THE DISCOUNT RATE
The discount rate is the interest rate the Fed charges to banks for short term loans to meet their operating needs. This rate is set by the Fed. If the Fed increases the discount rate it makes it less profitable for banks to borrow from the Federal Reserve. If banks reduce their borrowing, the total money in the banking system is reduced and the amount of money the banks have to loan out declines. As a result the money supply is reduced.
OPEN MARKET OPERATIONS
Open market operations are when the Fed buys or sells government securities like Treasury bills. When the Fed buys securities, usually from large banks, they are increasing the money supply. The banks will have more money to loan out. When they sell securities they are decreasing the money supply and banks will have less money to lend out.
BOTTOM LINE
The Fed uses its tools to control the money supply and keep the economy stable. When the economy is sputtering the Fed will increase the money supply to stimulate growth. In turn the banks will have more money to lend and will lower interest rates to their customers which in theory will cause people to borrow, invest and spend more. This in turn will cause businesses to produce more goods and services which in turn will require more workers and unemployment will go down. The goal is economic expansion. This sounds good but the unintended consequence can be inflation.
To combat inflation the opposite is done. The Fed will reduce the money supply. The Fed increases the reserve requirements, discount rates or starts selling government securities to reduce the money supply and reverse inflation. When this happens banks will have less money to loan out and the interest rates they charge their customers for car loans, mortgages, personal loans etc. will rise. These changes will have a direct effect on the economy as a whole. This will cause people to borrow and spend less, cause business to produce less which will require less employees and higher unemployment. The goal is economic contraction.
The Fed has recently been struggling to get inflation under control. The Fed has been increasing the discount rate quite rapidly which has caused interest rates to increase and unemployment to rise. Many people are afraid that these drastic increases could send the economy into a recession which will lead to high unemployment rates and reduced consumer spending because they will become more cautious with their money. It’s quite a balancing act.