Independent, Fee-Only Financial Advisor

Independent, Fee-Only Financial Advisor

Tuesday, June 14, 2022

How does the Federal Reserve work?

 The following blog post was written by our interns, Mauria Ferrell and Brady Gray. This is Part 2 of their series on the Federal Reserve.

As we talked about in Part I, the Federal Reserve is a central bank. They have a process they use to control the amount of money in the economy. The Fed can “create” money by giving commercial banks money to lend out to consumers. On the other hand, they can take money away from the banks, resulting in higher borrowing costs and effectively “destroying” money. The Fed is constantly trying to find a solution to keep our economy stable. It’s a continuous cycle that never ends.

Right now, they are trying to destroy money. During the pandemic we saw record low borrowing costs. That paired with fiscal policies of the government has created high inflation that we are seeing today. The Fed is trying to combat this inflation hike by destroying money and making the cost of borrowing higher. 

The Fed uses three main tools when conducting monetary policy. They are reserve requirements, open market operations, and the discount rate. They are used to grow or shrink the economy. Reserve requirements are the amount of cash that a bank must have on hand at any time. Open market operations refer to the practice of buying and selling U.S. Treasury securities. The Fed relies mainly on open market operations because this is how they purchase or sell bonds. The Federal Reserve also sets the discount rate also known as the Fed funds rate. It is charged to banks for the short-term loans they take from the Federal Reserve Bank.