What Does the Federal Reserve Do?

wiseGEEK Writing Contest

Since its inception, one of the chief functions of the Federal Reserve has been to regulate the country’s fiscal policy in order to maintain economic success in a fluctuating market. The economy is constantly influenced by unpredictable outside factors which can either affect the welfare of the system adversely or favorably. As a result, the Federal Reserve must have many resources to accommodate these changes. Otherwise, instability and economic crises might ensue. Unfortunately, even with all the tools at the Fed’s disposal, time lags often cause many problems in the attempts to improve the economy.

When there is too much money circulating in the economy and the supply of goods is not adequate enough to fulfill the needs or demand of the people, inflation occurs. Inflation would be a serious problem if the Federal Reserve didn’t know how to change the monetary policy accordingly. By cutting off the money supply, the Fed responds by taking more money into its base and stopping the printing of money. In addition to these strategies, people are encouraged to start saving by increasing the return on bonds, CDs, and savings account rates. When people spend less and save more, the inflation in the country’s currency can become stable once again, and prices will return to the most profitable and ideal rate, thus regulating the system.

When there is too little money circulating in the economy and the supply of goods is mostly out of reach of the consumers who need them, deflation, a recession or unemployment can occur. The rate of consumer spending decreases and as a result, businesses must lower the prices of their goods, therefore have less money to buy supplies and capital. The Fed regulates these problems by printing more money and dumping it into the economy. Attempts are made to encourage buying by paying for commercial advertisements. This increases demand, and, as a result, more people are buying products, increasing the need for more supplies. When this occurs, new workers are needed to accommodate the needs of the people. When the economy experiences high purchasing rates, nearly full employment, and high production an expansion of the economic system occurs until a peak is reached.

An in ideal system, these changes would be immediate, and the Federal Reserve would be able to manipulate the economic system at any time in whatever way they desired. But of course, real life conditions are different. Unforeseen occurrences cause lapses in the time of between the establishment of new fiscal policy and its effect on the economy. For example, when the Federal Reserve encourages saving by increasing the rate of return, the time it takes for people to start saving and stop buying causes there to be a lengthy time lapse before significant results can be seen. When the time lapses are too long, often there will be another policy change before the full effect of the first policy can be established. Keynes once likened the Federal Reserve to a ‘fool in the shower’. To get hot water, ‘the fool’ initially turns the lever all the way to the hot side. Then as he feels the water becoming hot he quickly turns the lever all the way to the cold side, and continues going back and forth without letting the full effects of either side settle in.

The great responsibilities of the Federal Reserve are effective in their goals, but because the full extent of the fiscal policy tools is never experienced, the true strength of the policy cannot be seen. Time lags negatively affect fiscal policy, causing the tools full efficacy to be left to the hypotheticals and theories of economists worldwide.

submitted by Katie Jordan