This is the interest rate that banks lend their balances on at the Federal Reserve to other banks. It exercises this control by influencing the demand for and supply of these balances through the following means:
Open market operations -- the purchase or sale of securities, primarily U.S. Treasury securities, in the open market to influence the level of balances that depository institutions hold at the Federal Reserve Banks (The Board's Publications Committee, 2005).
Reserve requirements -- requirements regarding the percentage of certain deposits that depository institutions must hold in reserve in the form of cash or in an account at a Federal Reserve Bank.
Contractual clearing balances -- an amount that a depository institu-tion agrees to hold at its Federal Reserve Bank in addition to any required reserve balance.
Discount window lending -- extensions of credit to depository in-stitutions made through the primary, secondary, or seasonal lending programs (The Board's Publications Committee, 2005).
The Fed's original and ongoing function has been to organize, standardize, and stabilize the monetary system in the United States. It set up a method that could create "liquidity" in the money supply -- in other words, make sure banks could honor withdrawals for customers. It also needed to come up with a way to create an "elastic currency," meaning it had to control inflation by making sure prices didn't climb too quickly, and it needed a way of increasing or decreasing the country's supply of currency in order to prevent inflation and recession (Obringer, 2002).
Why do we need the Federal Reserve System?
To answer this question it would be relevant to go back in time and remember why it was started in the first place. Before the Federal Reserve was created there were many different currencies in use throughout the U.S. Some of the currencies were backed by silver or gold, and others by government bonds. Some of the banks at times didn't even have enough money to cover withdrawals from their own customers.
Before the Federal Reserve was created, banks were failing, and the economy had extensive up and down swings. The confidence level Americans had in the banking system was weak. Imagine yourself in today's current economic situation, how uncomfortable you would feel with your money in the banking system without the FDIC insuring your funds. Knowing today that your account is insured and you can withdraw all of your funds if you need to is the reason the Federal Reserve is needed today.
Another reason we need the Federal Reserve System is to help control inflation and recession. Inflation is not good for the country because it slows down economic growth. For example, when inflation is high, products and services cost more and people cut back on spending. They also reduce long-term spending, such as constructing homes or buildings, starting new businesses, and investing in long-term options.
This insecurity makes people cautious of spending money for fear that inflation will intensify even more and they won't be able to pay bills and repay loans. High inflation also adds additional costs to long-term interest rates.
The nation needs a money manager because money does not manage itself. Money and credit are the lifeblood of the economy; they facilitate commerce, job creation, and business growth. As our nation's money manager, the Fed implements monetary policy to manage the flow of money and credit in the economy.
If money and credit expand too rapidly, businesses cannot produce enough goods and services to keep up with increased spending. Prices may rise, causing inflation. If the flow of money and credit contracts too greatly, spending and business activity may dwindle, workers may lose their jobs, and a recession may result. As our nation's money manager, the Fed conducts monetary policy to attempt to balance these two extremes to keep prices steady, workers employed, and factories productive (Federal Reserve Bank of San Francisco, n.d.).
Federal Reserve Bank of San Francisco. (n.d.). The federal reserve system is the central bank of the United States. Retrieved May 18, 2009, from Federal Reserve Bank of San Francisco: http://www.frbsf.org/publications/federalreserve/fedinbrief/central.html
Obringer, L.A. (2002, May 02). How the fed works . Retrieved May 18, 2009, from HowStuffWorks.com: http://money.howstuffworks.com/fed2.htm
The Board's Publications Committee. (2005). The federal reserve system purposes & functions. Washington, D.C.: Board of Governors of the Federal Reserve System.
The structure of the federal reserve system . (2003, July 8). Retrieved May 18, 2009, from federalreserve.gov: http://www.federalreserve.gov/pubs/frseries/frseri.htm