Moving forward from the last article ‘The Monetary System - 1: Money Supply’. Today you can explore the role of U.S. Federal Reserve in monetary system and money supply, while focusing on the current financial conditions.The primary role of the Fed (U.S. Federal Reserve) considered as the lender of last resort’ this was the reason why Fed had come into existence in 1913.
Fed controls money supply with its direct action-taking regulatory authority. Which includes, all banks to hold deposits with Fed as minimum reserves requirement (minimum reserves balance is what banks cannot lend out). If fed want to control credit, it raise reserve requirement and to increase lending reduce reserves rate. Fed actions also include, changing the interest rate on money that banks can borrow from the Fed. To pump liquidity, the fed start buying U.S. Treasury securities from the open/secondary markets under open-market operations.
Fed discount rate; the interest rate at which banks or financial institutions may borrow funds from Federal Reserve. As mentioned above, Banks or financial institutions have to keep set percentage of funds as reserve with central bank, this percentage is fixed by the central bank as bank rate. Any Bank, whose reserve dip below the reserve requirement set by the Fed, can use the money provided by central bank to correct their shortage and fed discount rate is the consideration for the usage.
So, the primary weapons of the Fed Armour are three-way’ First, by increasing or decreasing bank reserves, Second’ by changing discount rate and the Third’ by open market operations.
Further, in the present situation of liquidity shortage, where interest rates are almost zero or near zero levels the most common tool used by the fed is open market operations, carried out through FOMC.
Fed Open Market Committee (FOMC): As the name suggests, Federal Reserve’s open market operations are carried through the Fed Open Market Committee. The committee is an important action-taking unit of the Fed to manage and control the monetary system.
Open Market: The term open market means secondary market here, where buying and selling took place on the securities issued initially in the past.
Many people do wonder how the Fed creates money out of nothing to purchase treasury securities, if not printing afresh!
The Fed Open Market Committee purchase Treasury bonds or bills from banks and other holders by releasing cash that circulates in the system and increase the money supply. The money or funds require for the purchase, just created by making an entry in the electronic books.
Treasury Bonds’ are the signed and secure long-term instruments acknowledging Government debt, to pay fixed rate of interest semi-annually. One must remember, these bonds represent Government debt and issued by treasury (U.S. Treasury) and not by Fed. The fed usually buy and sell them through open market operations, as the tool to influence monetary supply.
Money Creation out of nothing!
There are trillions of dollars worth of U.S. Bonds floating in the financial system. That Fed purchases them through FOMC as open market operation. Fed pays for bonds purchase with electronically crediting the seller bank, which means the credit entries are based on nothing tangible.
The Fed just creates credit balances in the electronic books but seller banks (those sold bonds) have all the facilities, similar to the actually deposited funds with the Fed. So as the basic facility, seller banks can lent out ‘ten times’ the actual amount of their deemed reserves to new borrowers, at specific interest. This way the Fed increase the credit flows in the economy but without printing or issuing new money into the system.
Let’s Conclude
Typically, US Federal likes to work behind the scene and avoid getting involved in the topics of debates, clarifying their position. So the central bank avoided public statements before taking any action as an independent regulatory authority yet answerable to the US congress.
The basic role of the Fed is to preserve financial or monetary stability and to avoid financial crisis. The role of Federal Reserve much highlighted during the present economic scenario, the times termed extraordinary by Fed Chairman Ben Bernanke himself. The economic future of stability lies on the positives outcomes of the Fed direct actions.
Tags:
Monetary system treasury securities credit bank discount-rate interest rate market debt bonds money-supply the Fed Money Federal reserve role OMO FOMC Open markets operations U.S.
