Analyzing the Role of the Federal Reserve System Essay

Analyzing the Role of the Federal Reserve System

            The most important role of the Federal Reserve System in the economy of the United States is to create an environment that will generate jobs, sustain development and stabilize prices.  To realize that role the Fed formulates and implements the nation’s monetary policy, which will alter the money and credit conditions of the country’s financial system.

            The country’s economic performance and interest rates are affected by the flow of money and credit.  Money refers to currency in circulation and bank deposits by individuals and businesses.  Credit refers to funds loaned by banks and other lenders.  The Federal Reserve keeps an eye on both Money and Credit, making sure that the system does not have too much or too little of both.  When there is more money in circulation, banks will have more to loan out at low interest rates.  When interests are low, more people borrow money from banks.  With more money at their disposal, they are able to spend more.  When demand for goods increase, prices increase.  On the other hand, when there is little money in circulation banks have less to lend pushing interest rates up. Consumers borrow and spend less, driving both demand for goods and prices lower.  Businesses decrease production and consequently lost of jobs.  These inflationary trends are caused by excess, available money and credit in relation to available goods and services.

            In order for the Federal Reserve to sustain economic growth with full employment and stable prices, it has to have an effective Monetary Policy in place.  It must ensure that money and credit is paced just right and encouraging to business and consumer decisions.

There are three instruments of Monetary Policy, namely:  open market operations, discount rate and reserve requirements.  The major tool used to control the supply of Bank Reserves is the open market operations in buying and selling government stocks.  The Fed does business with Securities dealers on the basis of price.  It buys and sells Financial Instruments issued by the US Treasury, Federal agencies and enterprises sponsored by the government.         The Fed may create money to affect interest rates. It buys and sells securities to increase or decrease Bank Reserves.

            The Fed partners with a host of federal and state supervisors to guard the safety and security of financial institutions as well as the strength of financial markets.  The Basle Standards were Capital Standards measures that were created to arrest the sharp and massive decline of bank capital, notably, in the 1980s when the banking system and institutions were severely shaken and threatened.

            In the Basle Capital Standards, a bank’s regulatory capital levels, leverage ratio and its total risk-based capital ratio measure its risk performance.  Regulatory capital includes credit risk and market risk in trading activities.  This does not include interest rate and operating risks.  Capital Standards treat risks uniformly.  Take a mortgage loan as example.  An 8% capital is required for both corporations and households.  Risk-base Capital Standard is the prescribed capital for recourse obligations and direct credit substitutes, which expose banks and banking organizations to credit risks.

For not adhering to Capital Standards banks and banking institutions run several risks, like:  credit risks (if the other party has poor credit rating, and if both the borrower and the guarantor defaulted), the market risk, compliance risk and operational risk.   Without the Standards to fall back on, viability of banks and banking institutions may, like in the 1980s be threatened.

The Federal Reserve System in its most important role as Monetary Policy maker and implementer has a complimentary duty of supervising financial institutions and banks.  By ensuring a stable financial system, the Fed will be able to make appropriate monetary policy decisions leading to a healthy economy.

References

The Federal Reserve System (2008, August 13). About the Fed.  Fed 101.

Retrieved August 14, 2008 from http://www.federalreserve.gov/