The goal of the Federal Reserve is to “to promote sustainable growth, high levels of employment, stability of prices to help preserve the purchasing power of the dollar and moderate long-term interest rates” (The Federal Reserve: Duties, 2011). To sustain a healthy economy the Federal Reserve works as an over-seer and bank for financial institutions, the government, and is responsible for implementing monetary policy. As a bank to financial institutions, the Federal Reserve purpose is to monitor and maintain the efficiency of the banking systems. For the government, the Federal Reserve acts as a checking account for transactions placed by the government such as incoming tax revenue or payments. Government securities are also handled by the Federal Reserve. Any transaction dealing with bonds, notes, and treasury bills are included in the reserves duties to the government (The Federal Reserve: Duties, 2011).
The reserve is also responsible for issuance of U.S. currency. Even though they do not physical make the currency, they are in charge of distributing the currency to the various financial institutions. Money retrieved from the banks that have significant wear, is taken of circulation and replaced by the reserve (The Federal Reserve: Duties, 2011).
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As a financial over-seer, the Federal Reserve monitors the activities of U.S. banks as well as the foreign banks that have (expanded to the U.S.) established branches in the U.S. They act as authorities over any activities that occur between U.S. and foreign- owned banks. Laws, such as Truth in Lending and the Equal Credit Opportunity Act, which concern consumer credit, have been enacted on behalf of the Federal Reserve to ensure the public remains safe from any dubious activities brought on by banks (The Federal Reserve: Duties, 2011).Â
While the Federal Reserve is responsible for all of the activities listed above, their prime responsibility concerns the implementation of monetary policy. Monetary policy is the action the Federal Reserve takes to manipulate the quantity of money and credit within the U.S which directly affects interest rates. The Federal Reserve uses the Open-market operations, discount rates, and regulation of the requirements of the reserve to control monetary policy (The Federal Reserve: Monetary Policy, 2011). Open-market plays a role in monetary policy by the transactions the Federal Reserve maintains of the government securities. This affects the rate at which banks borrow money from one another also known as the federal fund rate.Â The Open-Market Operations is also effective in the controlling the interest rates by influencing the amount of money available in the banking system. Any changes to the discount rate on short-term loans to banks, is to make the markets aware of the Reserve's changes to the monetary policy and their future agenda. Â Reserve requirements are a set amount of funds that financial institutions are required to preserve “against deposits in bank accounts (The Federal Reserve: Monetary Policy, 2011)”. This is to ensure that banks sustain a portion of the physical funds within their own reserves. The amount that must be held is usually 10% and the rest could be used to loan or invest (The Federal Reserve: Monetary Policy, 2011). This also helps to avoid the cost it takes to hold the large amounts of money banks acquire. Any excessive amount of money is often held by the Federal Reserve.
Some of the factors that the Federal Reserve must contemplate before changing interest are the Consumer and Producer Price Index. The Consumer Price Index “examines the weighted average of consumer” commodities. The commodities are weighted by importance and any changes seen are used to evaluate any variations related to the cost of living (Consumer Price Index - CPI, 2011). It is used when determining episodes of inflation or deflation because major changes seen with the CPI within a short period of time, usually signify periods of inflation or deflation (Consumer Price Index - CPI, 2011). The Producer Price Index measurement of changes, over time, in selling prices of domestic commodities based on the sellers viewpoint (Producer Price Index - PPI, 2011). “The PPI looks at three areas of production: industry-based, commodity-based, and stage-of-processing-based companies (Producer Price Index - PPI, 2011)”.
The constant increase in the price of commodities is known as inflation. The purchasing power and value of the dollar depends on the effects of inflations (Inflation: What Is Inflation?, 2011). As inflation fluctuates the purchasing power of the dollar will increase or decrease depending on the rate. For example, if the rate of inflation is 4%, then a year later the value or goods and services will be 4% more than they were a year earlier.Â The influences the Federal Reserve has on interest rates, directly affect the fluctuations seen with inflation. Increases in borrowing cost in the credit market are usually a result of higher interest rates. In their attempt to sustain a healthy economy, the Federal Reserve has to control interest rates to sustain growth in the job market and stabilize commodity prices. The Federal Reserve must maintain a balance of the economy to keep consequences of letting it grow too much or slow at bay (Inflation: Inflation And Interest Rates, 2011).
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Any change of interest rates also affects the financial markets. If the federal funds rate increases it become more costly for a bank to borrow money from the reserve. Since businesses borrow money from banks they too will see an increase their rates and cease or reduce the amount they usually borrow from the bank. This will reduce company speeding since there will not be enough money to run daily operation or expand (Mueller, 2011). As a result, the company's growth will weaken causing a decrease in profits.
The value of a company changes due to differences of expectations placed on a company at any time. Whether the company meets those expectations determines if the company stock continues to sell. If a company's expected future cash flow decreases as a result of a decline in profits, the company stock price will decrease. If a considerable amount of companies experience these shortfalls, financial markets will begin to weaken (Mueller, 2011).
The interest rates are controlled by the Federal Reserve to maintain the balance of the economy (Inflation: Inflation And Interest Rates, 2011). With inflation playing a major role in what happens to the economy, it is important that the Federal Reserve try to maintain it through the changes they place on interest rates.Â If there is a rapid increase in growth in the economy, hyperinflation can occur causing a collapse in the financial system (Inflation: Inflation And Interest Rates, 2011). On the other hand if the economy is idle and unemployment is high, stagflation can occur. By increasing or decreasing interest rates, the Fed's strive to remain vigilant and proactive in trying to sustain the balance of the economy.