Bad Credit Finance

The Fed was originally formed in 1913 by the U.S Congress; there was no other organization in the States prior to then that served the role implementing and monitoring monetary policy. Initially monetary policy was a stabilization mechanism that injected enough cash and credit into the money supply and would therefore stop it from drying up, an occurrence that happened regularly prior to its formation and one that had created little faith in the banking system of the time.

As time moved on, and economic policies became more sophisticated, so the did the role of monetary policy. John Keynes’ theories became widely adopted and from around 1936 and the Fed’s role with monetary policy became one of economic stabilization and not just money supply. Its function as a lender of last resort came into effect as a preventative measure against financial panics.  Banks at the time were often hesitant to finance high risk business prospects; the Fed would then review this and provide the banks with the necessary funding.

The current Fed’s function is not only to administer monetary policy for a stable economy but is also to manage bank reserves.

The Fed has a “toolbox” with three main tools to administer to its function

• Adjustment of the reserve’s requirements
• Adjusting the discount rate
• Open market operations

Adjustment of reserve requirements

Reserve requirements are adjusted very rarely by the Fed, but it can have an immediate and great effect on the economy. The reserve is appointed by the Fed to the commercial banks and is a percentage reserve requirement, usually around 10%, that the bank must maintain in physical funds. A commercial bank makes money by lending and charging interest on the money that gets deposited; the maximum amount of lending is capped by this reserve percentage. Coincidentally it is because of this tool that the bank reinforces its name as a lender of last resort. If a bank goes below its minimum reserve for any reason, then the Fed will step in and assist the bank by lending it the funds to meet its minimum reserve.

Adjusting the discount rate

The discount rate is the rate that he Fed will lend money to the commercial banks for its short term loans. It is linked to but not the same as the federal funds rate (FFR). Markets take their lead from a change in the discount rate, as it is a way of determining the Fed’s future plans with regards to monetary policy. Should the Fed lower the rate it is a signal to the market that the Fed is trying stimulate the economy by making more money available and encourage spending. The opposite is true should the Fed increase the rate.

Open market operations

This is the most frequently employed monetary policy tool used by the Fed. It involves the buying and selling of government securities on the open market e.g. treasury bills. When the Fed buys a financial instrument on the open market, it releases funds into the system. When it sells a financial instrument it absorbs the funds from the system. The Fed does not decide with which dealers it will transact with, but rather its choice comes from the open market where the securities dealers compete.

By competing in the open market by buying and selling of government securities the Fed can have a huge influence on the federal funds rate. This is the rate that banks borrow reserves from each other. The Fed sets a target for this rate and uses the open market operations to try and achieve its goal.

The Fed’s actions in recent years have been both positive and negative and had a great impact on the financial crisis; the increase in the federal funds rate by 4.25% was one of the contributing factors that created so many defaults on the sub-prime mortgages. The consequent bail-outs of so many organizations would not have been possible if they were not funded by the organization.

The original goal of being the lender of last resort has expanded through the years, and although this idiom still holds true, the Fed’s role in stimulating and stabilizing the economy has become ever more crucial, its monetary policies must sustain the economic growth of the country, and at the same time try and attain full employment and stable prices.