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How the Fed Steers the Economy

     So what does the Federal Reserve do really? The Federal Reserve Act of 1913 states the role of the Fed as "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates". How curious. If you take this goal apart you will see that it is in reality in conflict with itself. Maximum employment would cause rapid wage and price inflation; two outcomes in direct conflict with each other. Absolutely stable prices would be the result of a flat economy, which would likely become a declining economy. Moderate long-term interest rates seems the most sanely achievable portion of the task the Fed has been given. How does the Fed juggle their seemingly conflicting tasks? A major vehicle the Fed uses to direct the economy is to increase and decrease liquidity and reserves in the banking system. By doing so the Fed can influence interest rates and the money supply. The Fed can increase liquidity by purchasing or selling government securities with member banks. The Fed can also effect liquidity and interest rates by increasing or decreasing the percentage of reserves financial institutions need to keep on hand to meet requests for funds from customers. A higher demand and low supply will increase interest rates and slow down an overheated economy. The reverse is also true. Excess bank reserves are traded between lending institutions overnight to insure they are in compliance with reserve requirements. A bank needing extra reserves will borrow them from another bank with a balance greater than reserve limits require. The rate of interest charged will be at the Federal Funds rate. The Federal Funds rate is the actual rate the Fed Board of Governors changes when the media reports a Fed interest rate increase or decrease. By increasing or decreasing the rates at which member banks can receive overnight loans from other member banks determines the domino effect of other rates paid by individuals and business. These resulting interest rates will cause the economy to expand or contract as the Federal Reserve deems is best for the economy at that point in time. Banks can also borrow directly from the Federal Reserve to increase liquidity at what is called the discount window. Funds will be lent at the Federal Reserve's Discount Rate.

    The Fed has many tools in its toolbox it can use to steer the economy. The Fed sets the percentage that can be loaned to an investor to buy stocks in a margin account, although many brokerage firms have even tighter margin criteria for risky or more volatile stocks. How much an investor can borrow on margin eases or tightens liquidity and this can also help fuel or slow the economy. Although a vehicle the Fed can use, the margin percentage is seldom changed. The Fed can increase confidence and allay fears by injecting liquidity into the system at a time of crisis or hardship such as a crop failure, the massive Mississippi River floods, or the fears surrounding the turn of the millennium. The Fed keeps a watchful eye on the economy and is constantly pushing the buttons and pulling the levers it deems necessary to keep us rolling along as smoothly as possible.

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