Federal Reserve Plays a Number

¶ … Federal Reserve plays a number of important roles in the United States economy. These include monetary policy, foreign currency operations, the supervision and regulation of the banking system, community affairs and involvement in the U.S. payments system (Federal Reserve, 2009).

The Federal Reserve is responsible for the implementation of monetary policy. The objectives of monetary policy are to promote long-term economic stability in the form of interest rates, prices and employment. The Fed seeks to achieve these objectives by controlling the money supply, balancing the need for economic stimulus with the need to contain inflation. The Fed funds rate is the primary tool to achieve this end. The Fed funds rate is a benchmark rate for the entire financial system, particularly other short-term rates. Lowering the rate loosening the money supply, raising the rate tightens the money supply.

In addition to the Fed funds rate, the Federal Reserve also impacts monetary policy through open market operations. The Fed sells or buys treasury securities in the open market, over the counter. Open market operations also serve to impact the money supply in the U.S. The Fed generally buys more treasury securities than it sells, adding liquidity to the financial system.

The third major tool of monetary policy is the reserve requirements. Banks are required to hold a percentage of their deposits with the Fed. These deposits are known as reserve requirements. Money held is reserve is money that the banks cannot lend, so the reserve requirements directly impact the amount of money in the banking system. By adjusting the reserve requirements, the Fed impacts liquidity in the banking system and can use this tool to control for inflation, but can also use this tool to manage systemic risk in the banking system.

Monetary policy not only impacts the amount of money in the economic system, but it also affects currency exchange rates. In addition to managing the value of the U.S. dollar through interest rate policy, the Fed also engages in foreign currency operations. This involves the buying and selling of U.S. dollars on global currency markets. Doing so can expand or contract demand for the dollar, thereby increasing or lowering its value. The Fed does this in order to create demand for U.S. products, or to help fight inflation.

In the Fed's role as one of the supervisors and regulators of the banking system, it has been gifted with certain enforcement mechanisms. The Fed can use both formal and informal actions to control the behavior of banks. The first step in enforcement is that the Fed will present to the managers of the bank in question all of its findings and demand that the issues be addressed. If the bank does not comply, the Fed will then request that the bank adopt a board resolution or memorandum of understanding. It is hoped that this action will compel the bank's board into action.