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The Federal Reserve – Its Past And Its Future Concerns

The Federal Reserve – Its Past and Its Future Concerns

The Federal Reserve seems to be in the news every day on TV, Twitter, and all the various media outlets.  Part of the reason for its prominent role in the news is its evolving strategy on monetary policy.  Let’s take a look at the history of the Federal Reserve and how its tasks have changed.  Then, we can start to make sense to its biggest fear today – deflation – and what it is doing about it.

A History of the U.S. Dollar

Before the Federal Reserve was created, you might be surprised to learn that the U.S. dollar was not always the sole currency in the U.S. Instead, currency was issued directly by banks backed by the deposits that they held on reserve and other assets. Each bank had different standards regarding leverage, reserves, and even had different exchange rates between banks. This was inefficient and led to many panics at the first sign of trouble.

There was no backstop if banks had too many withdrawals. If a bank had only $100 in the safe and ten people came in to withdraw $100, nine would walk out penniless. Getting to the front of the line was essential before the bank ran out of money. Old black and white photos of people waiting in lines at banks epitomize public distrust in the banking system. After the Panic of 1907, it became clear that banks needed to be regulated. It was also clear that a central authority to maintain the stability of the financial system was needed. Frequent bank panics led to the enactment of the Federal Reserve (Fed) in 1913 and eventually the Federal Deposit Insurance Corporation (FDIC) in 1933.

What is the Federal Reserve’s Function?

What does the Fed do? Besides regulating banks and keeping the financial system running smoothly, the Fed has two primary goals:

  • Maximum employment
  • Price stability

Maximum employment does not mean zero unemployment and price stability does not mean zero inflation. The goal here is to keep as many people employed as market conditions permit. By keeping moderate levels of inflation, the Fed can avoid the undesirable effects of high inflation or negative inflation.

An Example

Consider an example in which prices are rising extremely fast (hyperinflation). This means that the money you have today is worth less than it did yesterday. Restaurants have to keep changing menus, wages buy fewer goods, and cash shortages become common. These effects can destroy an economy and bring the financial system to a halt.

Consider the opposite scenario in which prices are falling fast (deflation or negative inflation). This means that money today is worth more than it did yesterday. It sounds great, but it also comes with negative effects. Large purchases are deferred, debt becomes more burdensome, and the process repeats into a recession.

The Federal Reserve’s Tools

How does the Fed accomplish maximum employment and price stability? The Fed has a variety of different tools to achieve its goals. The tool that regularly hits the news as of late is interest rates.

Interest rates affect nearly every facet of finance. Most importantly, it affects savings rates and lending rates. Lower interest rates encourage more borrowing because loans are cheaper, more borrowing means more spending, and more spending means more economic activity. This could make the economy grow.

The impact lower interest rates have on inflation works similarly. As more loans are being taken out, the amount of money in the economy is increasing. The greater amount of money in the economy, the higher the inflation.

Why is the Fed Reducing Interest Rates?

You might be asking yourself, if the economy is doing so well then why is the Fed reducing interest rates? What the Fed observed is that despite good economic activity and low unemployment, inflation is falling. The models anticipated inflation to increase with low unemployment, but it didn’t.  The Fed would like to keep inflation sufficiently high enough so that it’s neither too low nor too high. An inflation rate that is low in good times could reverse in bad times. By reducing interest rates, the Fed is taking a precautionary measure to protect against entering a deflationary environment.

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