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The Federal Government's Money Control

Updated on February 17, 2016

The Gatekeeper

Every efficient monetary system needs to ensure the creation, transfer, and supply of money is monitored and controlled. The United States has the Federal Reserve as a gatekeeper of money and its activities.

The Federal Reserve (“The Fed”) was created in 1913 to regulate the banking system and money supply of the United States (Melicher, 2005). The Fed is the United States’ Central Bank and establishes monetary policy that stabilizes the economy and controls money supply. Policy can be created in preventative measures or reactionary measures depending on the current economic status of the country.

The Fed implements monetary policy in three basic ways: Setting Reserve Requirements, Discount Rates, and through Open Market Operations.

Discount Rates

Discount rates are the interest rates banks pay Federal Reserve banks to borrow money to meet reserve requirements, depositor demands, or business loan demands (Melicher, 2005). Discount rates have a domino effect on prime rates because if banks pay more to borrow money; that increased rate is passed onto consumers and banks obtaining loans from that bank via the prime rate. For example, if a bank is charged two percent to loan from its district federal bank, and the Fed increases the discount rate to four percent; that bank is going to add two percent or more to its prime interest rates when offering loans to consumers to offset the increase by the Fed. This can also affect money supply in the same manner as bank reserves. If discount rates are increased, the bank’s demand for loans with higher interest rates may decrease, thus less money is available through the bank. In addition if the bank is offering higher interest rates on its loans, consumer demand will also decrease in response to paying more for a loan. In turn, the function of adjusting discount rates impacts economic activity through the money supply control.

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Federal Funds Rate

The Fed employs a Federal Funds rate, which is the rate of interest charged by a bank with excessive reserves to another bank it loans to with deficient reserves (Melicher, 2005). The Federal Open Market Committee’s (FOMC’s) use of Federal Funds Rate is the most useful tool to affect money supply. It affects the bank’s money supply, reserve levels, short-term and long-term interest rates, prime rates, interest on deposits, credit cards, mortgages, and even treasury-bill purchases (New York Times, 2011). This domino effect can extend its reach into housing markets, any tangible good demand and thus affect labor supply.

According to the New York Times (2011) “A higher fed funds rate means banks are less willing to borrow money to keep their reserves at the mandated level” (para. 1). This means they will lend less money out, and the money they do lend will be at a higher rate since they themselves are borrowing money at a higher rate; because loans at this point are more difficult to obtain and more expensive to finance, businesses will be less likely to borrow, thus slowing the economy. When the Fed raises rates, it is called contractionary monetary policy. Adjustable rate mortgages will become more expensive, so home-buyers can only afford smaller loans, which slows the housing industry. Housing prices go down, so homeowners have less equity in their homes, and feel poorer. They spend less, further slowing the economy. When the fed funds rate is decreased, the opposite occurs. Since overnight lending is cheaper, banks are more likely to borrow from each other to meet their reserve requirements. They lend more and at a lower rate. With cheaper bank lending, businesses expand; this is called expansionary monetary policy” (para.4).

The Federal Funds rate last changed December 16, 2008 from 1% to .25% in the amount of a .75% decrease. This had an intended impact on our economy to increase money supply and lower interest rates to increase economic activity due to the Housing Crisis which led to the stock market crash. These circumstances led to less spending by consumers, and thus lowered demand for loans and other non-necessity items as consumers and businesses had no faith in the market, and saved, reducing the money supply which also impacted the loanable funds. Thus the government used reduced the federal funds rate, which decreased the interest rates banks charge each other when lending and borrowing. Thus, prime rate, and other rates are derived from this amount, as it is what banks essentially “pay” each other, to have the money available to consumers. A lowered federal fund rate, lowers the prime rate so banks can offer funds at lower rates, increasing incentive and attraction to consumers and businesses borrowing funds. In turn, consumers were offered lower rates to refinance their homes, and buy homes. The government did not want the housing market to go stagnant. The rates allowed more loans to be offered at a lower rate, and attract first time home-buyers and eased the sale of some homes through increasing demand for loans through decreasing the discount rate, which decreased the prime rate. The Fed needed to make more loanable funds available to boost economic activity which would boost the GDP. This dip in the Federal Funds rate shows that at the time of economic turmoil, the rate was reduced in response.

Federal Funds Rate

Source

The federal funds rate dipped its lowest in the 8 year span shown at the end of 2008, which is when the impact of the of the housing crisis was felt by America. The Fed responded lowering the Federal Funds Rate which lowers the rate banks offer to consumers on loans. They had to increase the loanable funds.

The Loanable Funds Theory, pursuant to Melicher (2005), is a theory that “Interest rates are a function of supply and demand for loanable funds” (p. 182). Translated, this means that interest rates themselves impact the supply of or demand for money because consumers and businesses make their decisions to loan or give money based on interest rates they will pay for the money, or the money they get from loaning it. This theory ties into the basic law of supply and demand regarding the volume of loanable funds just as it does for goods and services. If loanable funds are in excess, demand is low, so interest rates will decrease to attract consumers and businesses to taking loans from the loanable funds. If loanable funds are low, it is because the demand for them is high, thus interest rates will increase to match the demand and stave off increased demand and inflation. Interest rates are assigned by banks in accordance with what they are paying as discount rate for funds, to establish prime rate, and offered rate.

Market Determinants of Interest Rates

There are a few major determinants of market interest rates that are taken into consideration after the federal funds rate is set, and thus prime rate is derived. The first determinant that is most important is the “real rate” of interest. The “real rate” is the interest on risk-free debt instruments that have no expectation of inflation to affect the value in the future (Melicher, 2005). The next determinant is the “inflation premium” which is the average inflation rate expected over the lifetime of the debt. Next, the “default premium” determinant is factored in; which is defined as the compensation charged for the possibility of borrower default, which is obviously applicant-specific. With these determinants we achieve a “nominal” interest rate which is the combination of the real rate of interest, plus inflation expectation premiums, plus default premiums. These determinants and the final rate are most commonly used in lending by banks, which is obviously first affected by the discount rate set by the Fed. This rate that is passed along to banks who borrow from the fed, then pass along an increased rate of prime plus what they determine is fair, and consumers are offered rates that match the current market conditions.

As demonstrated loanable funds may be created and affected, and in turn interest rates assigned, the group that is affected most in the end, are the ones that create the ability to loan: consumers. Interest rates and loanable funds supply can affect a consumer’s personal finances in many ways, and mostly it involves financial decisions. If interest rates are increased because of high demand of loanable funds, consumers may not borrow, if rates decrease because of low demand for loanable funds, consumers may loan more, and for more than they would before. Interest rates affect the overall net income after liabilities are paid, so if interest rates increase on a loan payment, less money is available to them for discretionary spending, or may increase too high where a default is the result. They may decline using a credit card if interest rates are too high on the card, or may resort to a credit card if the determinants used to assign an interest rate on a shorter term loan are too high. Interest rates may also be the catalyst for investment and saving, creating more loanable funds. If interest rate returns are higher in investment vehicles, they may opt to invest more, or contribute more to their pension or 401 (k), increasing the loanable funds supply and unknowingly changing interest rates one dime at a time.

The history of the prime rate shows that it has been at 3.25 since the beginning of 2009 after the 2008 economic crisis. Like the federal funds rate, the prime rate has stayed the same since. (Moneycafe, 2012)

Federal Funds Rate History

Gross Domestic Product

The Gross Domestic Product (GDP) was reported at $15,176.1 billion by the Bureau of Economic Analysis on December 22,2011 for the 3rd quarter review of 2011 GDP. This was a 4% increase from the 2nd quarter earnings. However, the history of GDP falls in line with the dips in federal fund and prime rates after the housing crisis. Below the graph depicts that our GDP was in the negative in 2008 and 2009.

Gross Domestic Product (GDP) is defined as the supply or output of goods and services in an economy (Melicher, 2005). Some monetarists believe money supply determines the level of GDP. Economists believe the link is between money supply and economic activity, and Keynesians believe, conversely to monetarists, that the link between money supply and GDP is not as direct because changes in the money supply first affect interest rates, which in turn affect the GDP only as a result of changes in consumption and investments (Melicher, 2005). Regardless of the opinions, they all intertwine; Money Supply does have an effect on spending, spending has an effect on economic activity, and economic activity has an effect on the GDP. Monetarists, economists and Keynesians seem to believe one affects the other; they all just have a different starting point on the “wheel of cause and effect”.

GDP

Source

Money Supply

Money supply is the total amount of currency, securities, and assets of the economy (Melicher, 2005). Money supply must be tracked as it is linked directly to economic activity. Money Supply is measured in three groups; M1, M2, and M3.

The Federal Reserve uses the M1, M2 and M3 totals to monitor and track money supply. If money supply is too low, interest rates are lowered by the Fed which lowers the rates banks offer consumers, the Feds lower the reserve rates for banks which frees up funds that were part of a higher reserve; thus money supply is increased and made more available to consumers and businesses allowing increased consumption and investing. If money supply is too high, then it must be reigned in to avoid inflation. Inflation is a result of too much money supply in an economy. When people have more, they spend more; in turn demand for goods and services increases and prices increase with that demand to stabilize demand, as well as profit. This activity also increases the GDP. The increase in the price of a good or service without an increase in quality is known as inflation (Melicher, 2005). Thus, to control inflation, increased interest rates and reserve rates restrict money flow resulting in less money available in the economy.

The Fed chose to increase loanable funds and money supply by decreasing the discount and federal rate so prime rate could be lowered and funds could be offered to consumers with attractive terms. The Fed had no choice but to do this, and continue, as you see in the years of 2008-2012, the lowered rates stay the same and the GDP is recovering due to expansionary monetary policies by the Fed.

Conclusion

The data proves this economy can endure a long bumpy ride; however the Fed claims responsibility for less erratic dips and dives. Although to the majority, the connotation of the Fed is that it is a power hungry group of greedy men and women pulling the puppet strings of consumers to affect the economy however; this type of control is needed to avoid recession and inflation while maintaining the value of the fiat dollar. Effective Monetary systems require guardianship; the Fed is the gatekeeper that fulfills this need.

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    • Tara Mapes profile image
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      Tara Mapes 3 years ago

      Agreed HSchneider, those who don't understand the monetary system often have negative remarks regarding its efficacy and results. However, through its trials, errors, and successes, we have learned, and are still learning how infinitesimal strategies and reactions can keep the economic boat afloat as changes in economic behavior spawn, and cycle through. Thanks for reading!

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      Howard Schneider 3 years ago from Parsippany, New Jersey

      Excellent Hub describing the American monetary system, Tara. It has been in place for the past 100 years and has had its fits and starts in trying to stabilize our financial system. The Fed took unusual actions during 2008 to keep this system afloat but it kept us out of another Great Depression. We certainly would have collapsed without it. Many feel it enables bankers but we would all have been on a bread line without their 2008 actions. The system needs to protect small investors more but the system still worked.

    • Tara Mapes profile image
      Author

      Tara Mapes 3 years ago

      Thanks JohnfrmCleveland.

    • JohnfrmCleveland profile image

      John 3 years ago from Cleveland, OH

      A very well-written article. I disagree with some of the monetarist arguments within, but you have put the mainstream thinking forth pretty effectively. Rated up.