If we view interest rates as being the cost of credit (which is for all intents and purposes the truth), then it’s easier to understand just what the Federal Reserve’s role is in setting United States monetary policy. As the governing body for affiliated banks, they help to determine what consumer credit policies should be, and the ensuing effect that that action is likely to have upon the economy.
In order to regulate things thusly, the Federal Reserve makes use of three main principles.
Open Market Operations
The first is open market operations. The Fed handles the transfer (buying and selling) of government securities, which of course directly affects the level of reserves that they have in the banking system at any given moment. This has a direct effect upon the price of credit (interest rates), so it’s a very effective means of monetary control.
Discount Rate
Next is the discount rate. We spoke already about how banks use the Federal Reserve as their own bank. The discount rate is simply the interest rate that the Federal Reserve sets on their short term loans to these banks. This is important because it’s a good indicator of what the Fed is thinking about the state of the economy and allows for insight into their plans for the future.
Reserve Requirement
Lastly, we have reserve requirements. As we all know, banks are only required to physically hold a percentage of the money that they actually have on deposit with customers. Which percentage they have to have is a matter that is closely regulated by the Fed. This fluctuates with how likely it is that customers will be making major withdrawals, and also with the cost of credit itself (and consequently how much physical banks need to have on hand).
Next time, we’re going to take a look at how all of these principles come together in the Federal Open Market Committee’s periodic meetings and directly determine the overall state of the economy as well as which monetary policies the Fed is going to enact next. This is the aspect of the Reserve that should be of most interest to investors, so we hope to see you then!
See you next week for part 5 of The Federal Reserve.
Sean Rasmussen
The Bullhunters Guide
Universal Wealth Creation © 2004 – 2008
{ 3 comments… read them below or add one }
Hi Sean,
It’s incredible to imagine that one banking system can have such power over world finances and amaizes me that we have allowed it to have such control over us. What position does the IMF occupy in relation to the US Federal Reserve in influencing world economics, affiliate banks, and governments?
all the best
Rob.
Hi Sean,
Again, great information. It’s amazing how much the Federal Reserve is actually responsible for. I can see why Woodrow Wilson wasn’t happy with the idea of it.
Yet, you’d think it would help to have an independent body in charge of the country’s finances. It doesn’t seem to work that way though.
It is a very complex network and difficult to understand at times because it involves the government but it isn’t essentially the government.
The fact that this system has been set up and operating for 100 years means it has become an accepted part of American life.