Throughout history, free market societies have gone through boom-and-bust cycles. While everyone enjoys good economic times, the downturns are often painful. The Federal Reserve was created to help reduce the injuries inflicted during the slumps and was given some powerful tools to affect the supply of money. Read on to learn how the Fed fights recession. (To find out more about recession, see Recession: What Does It Mean To Investors? and Recession-Proof Your Portfolio.)

Tutorial: An In-Depth Look At The Federal Reserve

The Evolution of the Fed
When the Federal Reserve System was established, its founders did not intend it to pursue an active monetary policy to stabilize the economy. The basic ideas of economic stabilization policy were foreign at the time, dating only from John Maynard Keynes' work in 1936. Instead, the founders viewed the Fed as a means of preventing the supplies of money and credit from drying up during economic contractions, as happened often in the pre-1914 period.

One of the principal ways in which the Fed was to provide such insurance against financial panics was to act as the "lender of last resort". That is, when risky business prospects made commercial banks hesitant to extend new loans, the Fed would step in by lending money to the banks, thus inducing banks to lend more money to their customers. (To learn more about the Fed, see The Federal Reserve.)

The function of the central bank has grown and today, the Fed primarily manages the growth of bank reserves and money supply in order to allow a stable expansion of the economy. To implement its primary task of controlling money supply, there are three main tools the Fed uses to change bank reserves:

  1. A change in reserve requirements
  2. A change in the discount rate
  3. Open-market operations

The Tools
A change in reserve ratio is seldom used but is potentially very powerful. The reserve ratio is the percentage of reserves a bank is required to hold against deposits.A decrease in the ratio will allow the bank to lend more, thereby increasing the supply of money. An increase in the ratio will have the opposite effect. (Read more on this subject in Breaking Down The Fed Model.)

The discount rate is the interest rate that the central bank charges commercial banks that need to borrow additional reserves. It is an administered interest rate set by the Fed, not a market rate; therefore, much of its importance stems from the signal the Fed is sending to the financial markets (if it's low, the Fed wants to encourage spending and vice versa). As a result, short-term market interest rates tend to follow its movement. If the Fed wants to give banks more reserves, it can reduce the interest rate that it charges, thereby tempting banks to borrow more. Alternatively, it can soak up reserves by raising its rate and persuading the banks to reduce borrowing.

Open-market operations consist of the buying and selling of government securities by the Fed. If the Fed buys back issued securities (such as Treasury bills) from large banks and securities dealers, it increases the money supply in the hands of the public. Conversely, the money supply decreases when the Fed sells a security. Note that the terms "purchase" and "sell" refer to actions of the Fed, not the public. For example, an open-market purchase means the Fed is buying but the public is selling. Actually, the Fed carries out open-market operations only with the nation's largest securities dealers and banks, and not with the general public. In the case of an open-market purchase of securities by the Fed, it is more realistic for the seller of the securities to receive a check drawn on the Fed itself. When the seller deposits it in his or her bank, the bank is automatically granted an increased reserve balance with the Fed. Thus, the new reserves can be used to support additional loans. Through this process, the money supply increases.

The process does not end there. The monetary expansion following an open-market operation involves adjustments by banks and the public. (To find out more, see Formulating Monetary Policy.) The bank in which the original check from the Fed is deposited now has a reserve ratio that may be too high. In other words, its reserves and deposits have gone up by the same amount; therefore, its ratio of reserves to deposits has risen. To reduce this ratio of reserves to deposits, it chooses to expand loans.

When the bank makes an additional loan, the person receiving the loan gets a bank deposit. At this stage, when the bank makes a loan, the money supply rises by more than the amount of the open-market operation. This multiple expansion of the money supply is called the money multiplier. Bank loans and purchases of securities are described as bank credit. It is the existence of bank credit that makes the money stock larger than the monetary base, also known as "high-powered money". High-powered money consists of currency and bank deposits at the Fed.

Looking for a Hero
Today, the Fed uses its tools to control the supply of money to help stabilize the economy. When the economy is slumping, the Fed increases the supply of money to spur growth. Conversely, when inflation is threatening, the Fed reduces the risk by shrinking the supply. While the Fed's mission of "lender of last resort" is still important, the Fed's role in managing the economy has expanded since its origin.

To read more about busting markets, check out Guard Your Portfolio With Defensive Stocks and Has Your Fund Manager Been Through A Bear Market?

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