The Federal Reserve was created in
1913 through the Federal Reserve Act.
The purpose of the Federal Reserve, or central bank, is to provide the
country with a safe, liquid, and stable monetary system. The Federal Reserve
does this by manipulating the Federal Funds Rate and changing the monetary
supply..
In times of financial panic, the
central bank tries to keep financial markets liquid and prevent the monetary
supply from tightening. To keep the monetary supply from decreasing, the Fed
can lower interest rates. When interests are low, individuals and businesses
are more likely to borrow money, because it is cheaper. When businesses and
individuals take out loans, they have money to spend, which can create economic
growth.
In the recent collapse, the Fed took many
unprecedented measures to create loose monetary conditions. They created
multiple programs that bought toxic assets from investors, which created liquidity
within markets. (If a market is liquid, the asset can be converted to cash
easily. This allows people to sell assets in return for cash, rather than being
stuck with assets that they couldn’t sell.) Another program called Quantitative
Easing was created to lower interest rates and increase the monetary supply.
This was achieved by buying Treasury Securities.
The Fed influences
the money supply and interest rates by setting a target for the Federal Funds
Rate. To reach this target, the Fed will either buy or sell large quantities of
Treasury Securities. When the Fed sells Treasury Securities, they deduct the
total cost the purchasing bank bought from that bank’s reserves. This bank is
then required to borrow money from other banks so they have enough money to
meet their required reserves. (The rate at which banks loan each other reserve
money is called the Federal Funds Rate, which influences almost every interest
rate.) The Federal Funds Rate will rise because there is more demand for
borrowed reserves. The opposite occurs when the Fed sells Treasury Securities;
interest rates decrease and the monetary supply increases. The Fed credits the
bank’s account allowing the bank to lend out more of their deposits.
Treasury Securities, such as bonds, bills or notes, are debt
obligations issued by the US government. They a very liquid asset and are
considered riskless because investors do not believe that the United States will
default on their loans.
