The Role of the Federal Reserve

The central bank of the United States is the Federal Reserve, also known as the Fed. The Fed performs many roles, but most importantly its function is that of a bank. Its main clients are not individuals or small business, however. Its main clients are other U.S. banks. Lately, the role of the Fed has been expanded to include the coordination of swaps and reverse repurchase agreements (repos) that involve other central banks and some of the largest and most influential banks of other home countries. In this fashion, the central bank of the United States can act as a “lender of last resort,” a bank that other banks can turn to in times of need. This need was most apparent during and after the economic and banking crisis of 2008–2009.

During those years the strength of the U.S. Federal Reserve was tested to the maximum. The Fed was called into action, and it provided liquidity to banks of all kinds by offering the exchange of “toxic” assets in place of “good” assets. The Fed did this by taking these rapidly deteriorating assets onto its inventory and exchanging them with the much-needed liquidity that the banks and investment banks of the United States required at that time. There is even evidence that the central bank of the United States offered and provided liquidity to foreign banks, including the largest Swiss bank, UBS.

If you are interested in the role that the U.S. Federal Reserve played in the crisis of 2008–2009, then you can do a bit of research on the subject. A good place to start is the Federal Reserve's website (www.federalreserve.gov) and the website of its biggest player, the Federal Reserve Bank of New York (www.newyorkfed.org/index.html).

Keeping the United States on Track

In addition to acting the role of lender of last resort, the Fed sets a few key policies that can have a heavy influence on the U.S. economy. These key policies can go a long way in keeping the United States on track or giving it a nudge in the right direction if its economy is too slow or too strong. First, the required reserve ratio is set by the Fed, and it refers to the minimum amount of money that retail banks are required to hold on tap for customers’ withdrawals. The reserve ratio acts as a limit on how much a bank can lend out in relation to its deposits. The lower the required reserve ratio, the more the banks can lend out per dollar of deposit. Lending out more has the effect of increasing money supply.

The Discount Rate

The second policy is the monitoring and setting of the discount rate. The discount rate is the overnight interest rate that the Fed charges the retail banks to borrow short-term money. If the rate is low, or goes lower, then retail banking institutions will borrow more from the Fed at a cheaper rate, and will then be able to lend the money out at a cheaper rate. The increased lending also has the effect of increasing money supply.

Open Market Operations

The third method of monitoring and controlling the money supply is through open market operations. Open market operations involve the purchase and sale of T-bills, T-notes, and T-bonds on the open market through a system of dealers, such as the nation's largest broker dealers and banks. It is often considered the most effective and most mysterious tool at the Fed's disposal. Purchases and sales can be done during different times, with or without notice to the public. The buying and selling of these instruments is a function that goes on every day. The Fed takes a reading of the market by contacting its sources: investment banks, brokerages, and other major players. It then enters into the process of buying securities if there is not enough money in the system and selling securities if there is too much money in the system. The whole process is usually done in secret, but lately there have been public announcements of such activity.

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