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The Federal Reserve is the nation's central bank. The institution has already been in the spotlight due to its relentless behavior of reducing or increasing interest rates. The US Congress founded the bank in 1913. Prior to its foundation, the nation lacked a centralized organization for carrying out monetary policy. Furthermore, the economies were volatile, and people had no confidence in the financial systems. The Federal Reserve is an autonomous body, but it is subject to control by the US Congress so that all of its decisions and operations must be approved by Congress, not the bank's president (Dennis, 2006). The paper will outline the meaning and functions of the Federal Reserve and the reasons they lower and raise the interest rates. Moreover, it will further discuss the influence of lowering and increasing the rates to the economy.
Meaning and Role of Federal Reserve
The Federal Reserve is the primary bank in the United States. It is the most powerful financial entity in the economy of the US and the world as a whole (Dotsey, 2004). The bank performs five primary functions that are aimed at maintaining the stability and efficiency of the America’s economy. For example, the Reserve manages the US’s monetary policies so as to ensure long-term interest rate stability, constant pricing of goods and services, and maximum employment. With the efforts of the bank, the country does not have to suffer from increased interest rates that affect the economy. Secondly, the Federal Reserve works to ensure financial structure and reduce the universal risks by monitoring the financial systems both locally and internationally. Moreover, the Reserve is in charge of carrying supervision measures on the private commercial facilities to ensure that safety of the systems and the impacts to the entire system is provided. The bank plays a role in promoting settlements and payment of safety through facilitations of transactions of the US dollar. Lastly, the Federal Reserve promotes the consumer safety and ensures community development through the facilitation of consumer-based evaluations, development, research, analysis of emerging trends, and making rules and laws that govern the activities. Besides, the bank can help in maintaining the US employment and stable prices for goods and services (Jovanovi & Zimmermann, 2008).
Why Raise or Lower Interest Rates
The Federal Reserve utilizes interest rates to influence the US economy. An interest rate is a price that is paid for borrowing money. The bank affects the economy by increasing or decreasing the interest rates the customer has to pay for the loan borrowed. The Federal Reserve changes the interest rates regularly to ensure that the US economy operates at an optimum state. For instance, when the economy is low or depressed, the Federal Reserve can react by making credits available to businesses, home buyers, and consumers. On the contrary, if the economy is fast growing, the bank can decide to increase the interest rates on borrowed money thus slowing down the economy and ensuring that it grows at a manageable rate. The effect of increasing the interest rates is to make the borrowing expensive so that the borrowers will end up paying more for loans (Reserve, 2005). Again, the savings and the money markets will accrue high interests. Alternatively, when the interest rates are low, people will earn low incomes on savings despite the increased ease to borrow loans. Moreover, the investors are likely to spend a lot of money thus giving companies finances to reinvest in their businesses. Furthermore, lowering or raising interests’ rates asserts control and influence over the economy by altering the process of buying and selling the treasury bonds. For example, when the Federal Reserve buys Treasuries from individual banks, it creates new money in the economy that did not exist before to pay for the bonds. The whole process increases the money supply in the system. The banks are always taking in money from depositors and lending it to other citizens. However, it is risky to lend out so much at one time because investors may demand their money back all at once (Dennis, 2006). It is evident that the Federal Reserve has to set a minimum amount of money that a bank should hold at a given time.
Economic Reactions to Interest Rates Changes
The Federal Reserve action of altering the interest rates has been met with a series of reactions. For example, when the interest rates are increased, the commercial banks react by increasing their interest rates thus affecting the consumer, car, home, and mortgage loans. Most important is that the commercial banks and other money lending institutions can alter interest rates before the Federal Reserve changes the borrowing rates. Similarly, when the Fed bank lowers the loan rates, the later should reduce their lending rates making the borrowed loans affordable (Cecchetti, 2009). The economic growth has remained steady and slow, yet the Federal Reserve officials are convinced that the economy is good enough. Some worries have emerged since the election of Donald Trump as the President of US. The investors are worried that the Trump will collaborate with the Congress on tax cuts thus creating barriers to imports and increase the inflation rate. The Federal official has claimed that they expect to raise the rates slowly to cater for the changing world’s economic markets. The challenge is that the officials and the Congress have to ensure that the economy does not suffer a disappointment that would make the financial sectors to fall (Reserve, 2005).
Federal Reserve Response to Economic Downturns
The US Federal official and the Congress have to react promptly to the economic challenges that could have been caused by increase or decrease in the interest rates. For example, Jovanović and Zimmermann in 2008 concluded that the US Federal bank responds to economic crisis and recession in several ways. First, it can lower or increase the borrowing rates depending on the economic environment. Secondly, the bank can sell and purchase the American government debt through the Treasury bonds and bills. Lastly, the bank can provide cheap loans to other financial institutions. The several measures help in restoring the economic stability of the country (Cecchetti, 2009). In 2007, the Federal Reserve responded aggressively to the financial crisis by implementing programs that supported the liquidity of the financial institutions and fostered the financial markets. The developed programs helped in improving the Federal Reserve balance sheet. The bank continues to take actions to fulfill its objectives for monetary policy that supports employment and money stability. Over the years the responses of the Fed involved substantial purchases of securities aimed at decreasing the pressure on long-term interest rates. Federal Reserve is actively involved in getting the economy out of recession. The government has to participate in activities that increase money circulation and ensure availability of money to the public for investments. Once people invest, the production rate is increased, and companies can employ more workforce. Moreover, the availability of money in the market makes the demand for goods and services to be high in the market (Reserve, 2005). It is evident that the Federal Reserve should monitor the economic pattern so as to ensure that the inflation rates are checked.
The Federal Reserve Bank being the primary financial entity in the US plays a role in monitoring the economy of the country. The institution maintains a careful watch on the interest rates, inflation, and the stability of the economy. The Fed has a lot of influence on the US economy because it is the leading bank that supplies the commercial banks with finances. The bank controls the economy by lowering and raising the interest rates on borrowed loans. The interplay of the macroeconomics makes it possible for the bank to influence the other monetary institutions. Despite the alterations made by the bank, it remains the main economic decision maker and financier of all other banks in the United States. The efforts of the Fed officials and the US Congress have led to economic stability and employment opportunities that have been provided by the Federal Reserve. The US controls the world's economy through the financial logistics provided by the Federal Reserve.
Cecchetti, S. G. (2009). Crisis and Responses: The Federal Reserve in the Early Stages of the Financial Crisis. Journal of Economic Perspective, 23(1), 51-75.
Dennis, R. (2006). The policy preferences of the US Federal Reserve. Journal of Applied Econometrics, 21(1), 55-77. Retrieved from http://qed.econ.queensu.ca:80/jae/2006-v21.1/
Dotsey, M. (2004). How the Fed Affects the Economy: A Look at Systematic Monetary Policy. Business Review, 15, 1-10. Retrieved from https://www.philadelphiafed.org/-/media/research-and-data/publications/business-review/2004/q1/brq104md.pdf?la=en
Jovanovi, ́. M., & Zimmermann, T. (2008). Stock Market Uncertainty and Monetary Policy Reaction Functions of the Federal Reserve Bank. Ruhr economic papers, 77.
Reserve, F. (2005). The Federal Reserve System: Purposes and Functions. Overview of Federal Reserve Systems, 1-182. Retrieved from https://www.federalreserve.gov/aboutthefed/files/pf_complete.pdf
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