Over the next few days we will look into the often mentioned, but rarely understood, Federal Reserve System of the United States. If that doesn’t sound familiar, maybe throwing out a few terms associated with the Federal Reserve System will jog your memory: The Fed, Ben Bernanke, inflation, federal funds rate, Alan Greenspan. The Federal Reserve System is most commonly referred to as the Fed, its chairman is Ben Bernanke, who replaced Alan Greenspan in February of 2006. To put it simply, the Fed is the banker’s bank. It was created out of necessity in 1913 to combat the “bank runs” that had plagued financial institutions. The bank runs were the result of public panics. Let’s say you think your bank is going to run out of money. You show up at the bank to withdraw all of your money and so does the rest of the bank’s patrons. The problem is, banks don’t keep every dollar you deposit in the safe. If you have seen “Its a Wonderful Life”, its something like that. If you haven’t seen the film, banks make money by taking your deposits and loaning them out to others. The end result is a bank doesn’t have all your cash in the drawer at all times.

The Federal Reserve Act was initially a bipartisan movement, but the final vote was closer to party lines with the Democrats pushing it through. Like our government, the Fed is the culmination of many compromises designed to keep special interests at bay. Prior to the creation of the Fed, the private banks of the country largely controlled the economy. At the same time, the government has its own interests and they should probably not be in control. The Fed is not funded by Congress, nor the banks. Everyone gets a piece of the pie with checks and balances. So the Fed’s first duty was to require all the big banks to keep their extra money in the Federal Reserve Bank, thus allowing for additional stability and lessening public bank runs. Since its inception the Fed has grown to adopt more responsibility. The most talked about responsibility is the Federal Funds Rate and inflation.

Federal Funds Rate and Inflation:
Many will support the argument that the economy is best when inflation is low. With low inflation, it is cheaper to borrow money. This is usually the backbone of the economy. Maintaining low inflation could be considered the unofficial mission of the Fed. By utilizing monetary policies, the Fed does their best to keep inflation in check (remember they are human). Monetary policy is enacted in various ways that we won’t go into because it can get pretty deep. The Federal Funds Rate is the primary monetary policy. This rate probably has the single most powerful impact on our economy. When this rate goes up, the rate on my savings account goes up. At the same time, it would make loan rates go up. This makes the cost of money more expensive. The cost of money is a very confusing statement. Now we will scratch the surface on the responsibilities of the Fed.

Let’s say you are loaning me money to start a business. If I borrowed $100 from you and gave you $105 back in a year, it cost me $5 to borrow your money. If I borrowed $100 from you and gave $110 back in a year, it cost me $10 to borrow your money. $10 > $5, making it more expensive to borrow money from you. This might keep me from borrowing the money in the first place. If I never borrow the money, I never start the business. I never make that contribution to the economy. Cheaper money fuels the economy but can create inflation risk. If the price of money decreases, the perceived value of a product might increase, inflation. Think $1,000 Nintendo Wiis on Ebay and a 0% rate credit card. This is perpetuated by a limiting supply of available money and a government that prints more cash. At the same time, if I were to borrow the $100 and pay back $110, I have to pass that $10 cost onto my consumers. Higher prices = inflation. Its the Fed’s job to keep all this in balance.

Reread that as many times are you need to. If you can get your head around that, you know all you need about the Fed. If you want to know more, come back tomorrow.

Related posts:

1. Weakon 180: Intro to the Fed, Part II
2. Weakon 180: Intro to the Fed, Part III
3. Weakon 117: Intro to Government Spending
4. Weakon 217: FDIC Insurance
5. Weakon 131: Mortgages

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