Research essay on the Federal Reserve- Feed Back

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The Federal Reserve and the Strength of the U.S Economy: A Research Paper

The Federal Reserve and the Strength of the U.S Economy

With inflation running rampant around the world and the strength of the U.S economy constantly being questioned it is often asked who is responsible for fighting inflation and ensuring the strength of the U.S economy. This is where you can look the United States Federal Reserve. The year over year inflation rate from October 2021-2022 is 8.2 percent (U.S inflation calculator). This is a staggering number when comparing it to the average inflation of the past one hundred years being 3.29 percent annually. While most data predict inflation to be slowly coming down it will take a lot of work to get it to normal rates as well as in 2022 the United States experienced two quarters of negative gross domestic product (GDP) which usually means recession. This research paper will focus on how these issues can be fixed namely, The Federal Reserve can influence the rate of inflation, the overall strength of the United States economy and banking system through the tools and power they possess.

To understand how the Federal Reserve operates and is tasked to do what it does today we must first look back at the history and why the organization was created in the first place. The Fed was created in response to a severe banking panic in 1907. "Bank run that wreaked havoc on the fragile banking system and ultimately led congress in 1913 to write the Federal Reserve Act" (Fed ST. Louis, pg.1, 2022). The Fed was created by Congress through a bill they wrote, when they were first created it was to strengthen the banking system to ensure banks didn't collapse and hurt the valuation of the dollar or overall economy. Today while the Federal Reserve is still tasked with those duties, they also have other responsibilities will be explained. Since the Federal Reserve is the central bank of the United States their responsibilities fall into four general areas. "Influencing money and credit conditions, supervising and regulating banks, maintaining stability of financial system, and providing financial services to the U.S government and institutions" (FED.GOV, Pg.1, 2022). In modern times you can see the responsibilities of the Fed are much broader than when it was first created in 1913. These broader responsibilities ensure they have the tools and authorization to be able to influence the economy and things like inflation. The last important piece of information to know about the Federal Reserve is who the chairman of the Fed is, this is the person at the top making all the final decisions on what they must do in terms of monetary policy. Jerome Powell is the current chairman and will be for the next 4 years as he was just re elected and they serve for 4-year terms. The board of the reserve consist of seven people with Powell being at the top. He is in control of the tools available to the Federal Reserve to fight inflation and influence the economy and banking systems in the United States.

A tool the federal reserve has to their disposal is monetary policy. "Monetary policy influences inflation and the economywide demand for goods and services and the demand for employees who produces those goods and services" (FED.GOV, Pg.1, 2022). Monetary policy is basically the actions and tools the Federal Reserve use as a whole to promote the best economic conditions possible. Looking forward to an example of monetary policy the federal funds rate would be an example of monetary policy used by the fed. Any action taken by the fed to promote economic prosperity and low inflation is looked at as monetary policy. All the examples talked about in the next couple of paragraphs about the tools the Federal Reserve has access to for the purpose of fighting inflation and keeping the economy strong will be examples of monetary policy.

The tools available to the Federal Reserve to fight inflation and keep the economy strong vary. One of the most notable when it comes to fighting an above average inflation rate like we have today is the federal funds rate. "The federal funds rate is the main benchmark interest rate that will influence how much money consumers pay to borrow or are paid to save" (Foster, pg.1, 2022). This rate set by the fed is the basis for all borrowing of money. Because the rate at which you can borrow money is set by the Federal Reserve, they can control how expensive it is to borrow money or how cheap it is. For example, during the Covid 19 crisis the federal reserve set interest rates to zero making it very cheap historically to borrow money. This was done to stimulate the economy in a time where people were locked down and not spending any money or going to work. This is one of the reasons the housing market began to explode in 2020 and 2021 because it was cheap historically to borrow money for a home. Since inflation started to skyrocket the Fed needed to do something to slow it down and bring it back to normal levels. This was the start of the fed increasing the federal funds rate in 2022. This was done to make it more expensive to borrow money which in turn will help bring inflation down. This rise in cost to borrow money will slow down the demand for goods and services. This is one of the Feds main tactics and tools they have in fighting and influencing inflation.

Another highly effective tool used by the Federal Reserve to fight inflation and keep the United States economy strong is the act of buying and selling bonds in the open market and having reserve requirements for all U.S banks. The act of buying and selling bonds in the open market is a tactic that changes the supply of money. "If the Fed buys bonds in the open market, it will increase the money supply by swapping bonds for cash to the public and vice versa if they sell bonds, it will decrease the money supply" (Petroff, pg.1, 2021). Given the fact that the Fed has control over the money supply by simply injecting the open market with money via buying bonds or in turn selling bonds to take money out of the market shows how much control they really have over the economy. The ability to be able to control the money supply is very important regarding inflation. If money supply is too high like it got to during the 2020 Pandemic, then inflation will increase as the money supply is moving faster than the goods produced. Therefore, the federal reserve started to sell bonds into the open market in 2022 to take money out of the circulating money supply to slow inflation and hopefully bring it back down to a normal level. This is where you will hear about the Federal Reserve balance sheet which includes all the assets they own and could potentially sell or buy to the open markets. Bank reserve requirements are another tool set in place to protect the banks from things like the bank runs in 1907 that was the main reason congress went ahead and formed the Federal Reserve. Bank requirements set by the Fed are "the amount of funds that a bank holds in reserve to ensure that it is able to meet liabilities in case of sudden withdrawals" (Chen, pg.1, 2022). This rule was obviously put in place to prevent bank runs like in 1907. This reserve requirement makes sure that the banks have enough money to meet all sudden liabilities. This also ensures that banks do not fail which would be bad for the economy and the U.S dollar which is important to keep strong. This system also ties into the federal discount rate, if a bank does not have enough funds to meet the reserve set by the Fed they can borrow from other banks or from the central bank. The amount of money it will cost to borrow these funds is determined by what the federal discount is at the time. Just like interest rates during the 2020 Covid-19 pandemic the reserve requirement was set to zero to increase the money supply so the economy could fight back shutdowns and not completely crash and burn.

The tools the Federal Reserve use are obviously effective and needed in today's day and age to keep inflation down and keep the U.S economy running strong. In practice these tools are just as strong as they are in theory. There is extensive history of the Feds use of these tools during times of economic distress. The Great Inflation from 1965 to 1982 is a great example of just that. This was a very defining moment for the federal reserve as everything was at stake. During the time of the Great Inflation Paul Volcker was the chairman of the Fed and making all the decisions when it came to monetary policy. "To fight inflation which peaked out at 15 percent year over year Paul Volcker raised interest rates up to 19-20 percent" (FedResHistory, pg.1, 2022). This is a staggering number when it comes to the federal funds rate, this made borrowing money very expensive and pulled a lot of liquidity out of the markets to really kill the horrible inflation. To put this into perspective today interest rates are at 4.5 percent and just the increase from zero to 4.5 percent has had dramatic effects on the economy and borrowing money. Volcker's bold tactics ended up working as inflation dropped to normal levels at about 3.5% towards the end of the crisis. Although there always will be times of economic distress the Federal Reserve works to fight back and bring the economy back stronger as well as keep inflation at bay.

One of the more well-known times of economic downfall in today's day and age is the Great Financial crisis of 2007-2009. This was also a big time for the Federal Reserve as they had their work cut out for them to try and fix the mess cause by the collapse of the housing markets. The Fed acted quickly to try and support the economy. "The Fed also cut its federal funds rate to zero and began a series of large-scale purchases of U.S treasury and mortgage-backed securities" (FedResHistory, pg.1, 2022). These actions by the Fed prevented the Great financial crisis or knows as the Great Recession as well from not being any worse than it already was. They were also creating programs to help the banks meet the reserve requirements. While we are in a somewhat similar situation today with the federal funds rate going from zero in 2020 to now above 5% as the Fed fights inflation its important to notice that when looking back in past times of economic distress these actions taken by the Federal Reserve are always in the best interest of the economy. History shows us these tools work to fight inflation and keep the U.S economy strong and moving forward even if there are a couple years of distress here and there as that is normal.

The 2007-2008 financial crisis also created new programs to stop banks from holding so much money in their reserves which came from the Fed stimulating the market, just as they did in 2020. "In October 2008, Congress granted the Fed the authority to pay depositary institutions interest on reserve balances held at reserve banks" (FRBSF, Pg.1, 2012). This basically made it, so banks did not want to hold so much cash that they were over the reserve limit. A lot of banks were doing this at the time, and it was a problem because money was not flowing through the economy. This interest rate of excess reserves by the Fed forced the banks to loan the money out of other smaller banks or people looking for loans. This new form of monetary policy fixed a problem that had never occurred before. The formation of new monetary policy and the Federal reserve's ability to adapt to new situations shows just how effective they can be.

Knowing the history of the Federal Reserve makes it easier to understand the how they operate and what their main purpose is. While they were initially created to start a new banking system in the United States through a bill in congress their responsibilities have increased significantly. The tools and power they possess give them the power and responsibility to ensure the strength of the U.S economy which includes fighting inflation when it's elevated like today. Now, having a basic understanding of these tools and how they work to accomplish those goals makes it very easy to realize that the Federal Reserve has a huge impact on the economy and inflation. Whether it be from monetary policy, the federal funds rate, or even bank reserve requirements all these tools and actions by the Federal Reserve are done for specific reasons to ensure the strength of the United States economy.

Works Cited

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