The Role of the Federal Reserve in the Economy

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Question: What does the Federal Reserve take into account when establishing general and specific rates of interest?

Answer:
The Fed looks closely at the aggregate economy, whether overheating or cooling, before it applies general and specific rates of interest. An overheating economy is manifested in a situation where the resources of the economy cannot cope up with, for example, increased demand for goods, increased production capacity of factories, uninterrupted loans from banks. Or when the economy has more money in circulation than what the actual goods and services can provide. This scenario will result to inflationary situation (a continuing increase in the price of commodities-- dangerous for the consumers). To avoid this, the Fed would simply increase interest rates to entice investors and consumers to save their money in the bank rather than investing in business.

On the other hand, a significant reduction of money circulating in the economy is also detrimental. This will result to deflation (a continuing decrease in the price of commodities-- dangerous for business). To avoid this, the Fed would simply decrease interest on saving and loans. This will discourage savings and entice business persons to withdraw their money in the banks and invest in business which will give them higher returns on investments (ROI).

Question: Describe the recent tools the Federal Reserve has used to influence the U.S. economy, and explain their effects.

Answer:
The Federal Reserve being the central bank for the US banking system is empowered with monetary tools to stimulate the US economy. These tools are:
1.Federal Reserve Open Market Operations
This is the most potent monetary tool available to the Federal Reserve. This involves buying and selling of government securities such as treasury bonds, bills, and notes. The purpose of this tool is to siphon off excess money circulating in the economy.

The effects of this tool to the economy is clearly discussed in the examples below:
For example, if the Fed wants to increase the money supply in a bid to stimulate the economy and encourage spending, the Fed will buy securities from financial institutions. The Fed pays for these transactions by crediting the institution's account at its regional reserve bank. All member banks of the Federal Reserve ...