Although from a macroeconomic point of view the Fed’s crucial role is to control the money supply, the Fed also performs several important functions for commercial banks. These functions include clearing inter-bank payments, regulating the banking systems, and assisting banks in a difficult financial position. The Fed is also responsible for managing exchange rates and the nation’s foreign exchange reserves. In addition, it is often involved in inter-country negotiations on international economic issues.
In the early 1980s, for example, then Chair Paul Volcker played a major role in negotiations with foreign governments on issues relating to the debt problems of developing countries. Clearing Inter-bank Payments If one writes a check of $100, drawn on your bank, the first Bank of Frenso (FBF), to pay for tulip bulbs from Crockett Importers of Miami, Florida. Because Crockett Importers do not bank at FBF, but at Branco de Miami, how does your money get from one’s bank to the bank in Florida? (Case and Fair 492) The answer would be that it is the Feds responsibility.
Both FBF and Branco de Miami have accounts at the Fed. When Crockett Importers receives your check and deposits it at Branco de Miami, the bank submits the check to the Fed, asking it to collect the funds from FBF. The Fed presents the check to the FBF and is instructed to debit FBF’s account for the $100 and to credit the account of Branco de Miami by the same amount (Case and Fair 492). So, the two banks have effectively traded ownership of their deposits at the Fed. The total volume of reserves has not changed, nor has the money supply.
Other duties of the Fed The Fed also acts as the lender of the last resort, i. e. it provides funds to troubled banks that cannot find any other sources of funds. The Fed is the ideal lender of the last resort for two major reasons, firstly, providing funds to a bank that is in dire straits is risky and likely not to be too profitable, and it is hard to find private banks or other private institutions willing to do this. The Fed is a non-profit organization whose function is to serve the overall welfare of the public.
Secondly, the Fed has an essentially large supply of funds with which it can bail out banks facing the possibility of runs. The Fed also has the authority to control mergers between banks, and it is responsible for examining banks to ensure they are financially sound and they conform to a host of Government accounting regulations. CONTROLLING THE MONEY SUPPLY If the Fed wants to increase the supply of money, it creates more reserves, thereby freeing banks to create additional deposits by making more loans. If it ants to decrease the money supply, it reduces the reserves.
Now, this may be the process described in a nutshell, but in order to perform the above tasks the Fed has 3 main tools available which make it possible for the Fed, namely, the required reserve ratio, the discount rate and open market operations. Required Reserve Ratio is the percentage of its total deposits that a bank must keep as reserves at the Federal Reserve. A decrease in the required reserve ratio allows banks to have more deposits with the existing volume of reserves. As banks create more deposits by making loans, the supply of money (currency+deposits) increases (Blanchard 125).
The reserve is also true: If the Fed wants to restrict the supply of money, it can raise the required reserve ratio, in which case banks will find that they have insufficient reserves and therefore must reduce their deposits by ‘calling in’ some of their loans. The result is a decrease in the money supply. Discount Rate is the interest rate that banks pay to the Fed to borrow money from it. The more banks borrow from the Fed, the more loans they make, which obviously leads to an increase in the money supply.
Now if the Fed wants to increase the money supply, it’ll decrease the discount rate, allowing commercial banks to increase the amount of money they loan out, and vice versa. Open Market Operations When we use the term open market operations, it refers to the issuance or sale and purchase of treasury bills / government securities to the public. It is a tool used to expand or contract the amount of reserves in the system and thus the money supply. Incase the government issues securities to the public, in layman terms, it simply takes away money from public and hands them a piece of paper, thereby reducing the money supply.
Similarly, on the other hand, the Fed may purchase these securities, when required, and this would result in an increase in Money supply in the economy. Bibliography Brue, Stanley L. , Campbell R. McConnell. Macroeconomics. 17. McGraw-Hill/Irwin, 2006. Blanchard, Olivier . Macroeconomics. 3. Prentice Hall, 2002. Blanchard, Olivier . Principles of Macroeconomics. 4. South-Western College Pub, 2006. Case, Karl E. , Ray C. Fair. Principles of economics. Prentice Hall, 2004. Mankiw, N. Gregory. Macroeconomics. 5. Worth Publishers, 2002.