The Federal Reserve System was formed primarily as a response to a recurring series of banking panics in the initial years of the 20th century. However, the most crucial function it serves to the economy of the United States is the centralization of banking for the sake of stability. This is accomplished by facilitating exchange of payments and responding to the liquidity needs of regional banks.
In effect, it assists in strengthening the economic standing of the United States in the global economy by regulating the nation’s money supply through the manipulation of interest rates and the availability of reserve funds in various ways. First, it can grant liquid reserves to banks by purchasing government securities. By doing so, it can stave off the demand for money in such a fashion as to bring down interest rates. This effectively makes the cost of credit lower and makes the granting of loans more profitable with the intention of ensuring the economy does not stop moving.
Second, it can adjust the discount rate on the loans it gives to banks in order to discourage or encourage the borrowing of funds. If the Federal Reserve sets the discount rate below short-term interest rates, it can stimulate growth credit. If it sets it above that rate, then there is no reason for banks to borrow from the central bank. Third, the Federal Reserve may set the requirement of liquid reserves that banks must maintain. If they set it higher, then the granting of loans becomes restricted and if they set it lower, granting loans becomes looser.
Fourth, it may also directly manipulate the money supply in such a fashion as to affect the federal funds rate, which is the rate by which banks lend their balance to other banks. While there is no shortage of criticisms that have been made about the Federal Reserve System, its existence is responsible for the present flexibility of financial transactions and without it economic interactions would be much more problematic and unstable.
Johnson, Manuel H. 2007, June 24. Federal Reserve System. The Concise Encyclopedia of Economics. http://www. econlib. org/library/Enc/FederalReserveSystem. html (accessed September 20, 2008). Obringer, Lee Ann. 2008. How the Fed Works. HowStuffWorks. http://money. howstuffworks. com/fed. htm (accessed September 20, 2008) No author. 2007, August. Fedpoint: Federal Funds. Federal Reserve Bank of New York. http://www. newyorkfed. org/aboutthefed/fedpoint/fed15. html (accessed September 20, 2008)