After the first post about the Fed and how they influence interest rates, I thought a more in-depth explanation would be in order. The flow chart in the previous post covers the basics, but it might leave you asking "What are securities?" or "Who is the Fed?"
Those are actually pretty common questions. Dont feel bad if you find yourself wondering them! Here's a simple, in depth, explanation of the Fed and how it works:
What is the Fed? The fed is a nickname for The Federal Reserve. You could accurately say that it is the central banking system of the United States. Originally the Federal Reserve was set up to aid the nation in times of financial crisis; now it's reach spans from conducting the nation's monetary policy to controlling the actual amount of money the US has in circulation. Pretty big job, right? When referring to decisions the fed makes, the actual body, or bodies, that are being referred to is the Board of Governors for the Federal Reserve, and the Federal Open Market Committee. The Board of Governors has seven members including the Chairman and Vice-Chairman. These guys are presidentially appointed for 14-year terms. The current president of the board is this guy:
Ben Bernanke is considered by many to be the most powerful man in the united states because of his influence as the Chair of the Fed.
The Federal Open MArket Comittee, of FOMC, consists of 12 members, which includes the Board of Governors and the president of the Federal Reserve Bank of New York. The FOMC meets eight times a year to discuss fiscal policy, and as needed over the phone, plus after serious economic changes in the US.
What do they do? We've covered that they set monetary policy to regulate the amount of money in the US, but how do they do this? The monetary policy part is a complicated bureaucratic system, like any other policy-making process; we're not going to cover the details of that today. What we are concerned with is what tools the Fed uses to influence the US economy.
Like the flow-chart I used before explained, they have basically three tools to use to influence the economy. Before discussing what the tools are, it is important to understand a crucial principle: there is only a certain amount of money available and it is subject to value changes based on supply and demand. This is an idea that is hard for some people to get their brains around, but it's an important one. To understand this, think of taking out a home loan. When you do this, you pay for it through the interest rates. This interest rate is very much like the cost of a good like gasoline: when there is more of it it costs less (as long as all other factors are constant).
Open Market Operations: This is the best tool the Fed has to manipulate the economy and the only one they would use most of the time. What is meant by open market operations is the buying and selling of securities. Securities are like investments that the country makes. Think government bonds. These can get pretty complicated pretty quick, so we're going to keep it simple: when the government buys securities, it puts more money into circulation. That isn't too hard to think about though, as when you buy something, you give out money. That's what the Fed does when they want to quickly increase the amount of money in the system. Following the laws of supply and demand, as money becomes more abundant in the economy, it becomes cheaper to buy: lower interest rates.
Reserve Requirements: The Fed doesn't use this tool too often, as it can cause problems for small banks when it does. The Reserve Requirement is, simply put, how much the fed requires banks to keep in reserve for each dollar it is holding on to for you and I. This is measured in a percent. To fully understand how this works, you need to understand that when you give a bank your money, it takes that money and literally creates more money from it. Not earns money from an investment, it creates money where there was no money, increasing the overall money supply. That is a complicated topic in of itself, so we will save that for another day, just know that it happens. So, given that, when the Fed lowers the reserve requirement banks have more money to work their bank alchemy with and the amount of money overall goes up. Again, supply and demand: this makes rates go down.
Discount Rate: This one is, in my opinion, the most boring (which is saying something when you're talking about financial policy!) The discount rate is the interest rate that the Fed charges banks to borrow from it. They generally only do this when they are running low on reserves. The principle here is simple: if the banks have a lower fee for borrowing money, they have more money to work with. More money in the banks' hands means more money overall. Supply goes up, price (interest rate) goes down.
So that's the gist of it! As you can see, it's really not that complicated when you break it down.
For more posts from Amerifirst Financial, visit our blog at www.amerifirstblog.us!
For further reading: