The federal reserve system - Essay Example

The Federal Reserve, or the central bank, is among the most powerful economic institution in the United States of America. The Federal Reserve was given the power over regulation of the value of money by congress. In simple terms, the Federal Reserve came into being by enactment of the Congress. Consequently, the Congress has the obligation of overseeing the monetary policy and the Federal Reserve. This paper analyzes the importance of the Federal Reserve and strategy in stabilizing the economy of the country.

The Fed System consists of a board of Directors, 12 regional bank branches in major US cities, and the Federal Open Market Committee (FOMC), the decision making unit of the Fed (Wells 19). The functions of the Fed are vital to the economy of the US as they play a major role in management aggregate demand, total spending, and most importantly, inflation. In the management of aggregate demand, the Fed applies relatively accurate counter-cyclical monetary policy to manage economic activities or aggregate demand.

This translates to the essence of monetary policy in the business cycle; the recessions and booms are direct effects of monetary policy set in place. Ultimately, the stability economic activities depend on the stability of the monetary policies. The monetary policy upheld by the Fed also determines the inflation rate in the country. The government at times uses inflation to increase tax revenues thus reducing its debts. On the negative side, inflation disrupts the price system, thus affecting the free market economy.

From these deductions, the lasting solution to inflation is stabilizing prices. This can be made one of the monetary policies of FOMC by the Congress. Another important role played by the Fed is that of being the lender of last resort. During crises, the Fed may increase the reserve or liquidity demand requirements thus automatically preventing liquidity shortages and stabilizing the economy. These liquidity reserves need to be adequate and available in economic crises. The Fed also influences the interest rates of major economic sector like automobiles, investments, and housing.

The Fed, through its Federal open Market Committee (FOMC) unit, controls the economy of the nation through its monetary policy. Monetary policy is the strategy of either decreasing or increasing the supply of money to enhance a stable growth of the economy. The Fed, with the authority installed upon it in the Monetary Control Act of 1980, may influence the economy through its three main tools; reserve requirements, open market operation or interest rates (Wells 4). On the reserve requirement, the Fed may impose a reserve requirement ratio that is either lower or higher than the prevailing ratio, depending on the nature of the crisis.

This rule applies to all the operational banks regardless of their membership to the Fed. An increase in the reserve ratio requirement decreases the supply of money in the economy, and vice versa. To understand this concept, let us assume that the Fed has imposed a 10% reserve requirement on banks. This translates to 10% of all deposits made. Some calculations translate to ten times the amount of money created, or in general, 1/R, where R is the reserve requirement ratio. Since the banks require only 10% of the amount deposited by their clients for reserve, the actual deposit equals 10% of the number of loans the bank can create.

Therefore, the number of total loans a bank can create equals to the actual deposit divided by the reserve requirement. The reserve requirement ratio is very powerful tool, and has only been used twenty two times in a period of 40 years. Nevertheless, the reserve ratio has been maintained at 50% since 1974. The discount rate is also biased by the FOMC for stability of the economy. Discount window is an economical term that refers to the Feds when it lends out money to banks, and the interest rate is known as the discount rate (as the banks turned assets in exchange for cash). For