How the Federal Reserve Can Help the Recession

How the Federal Reserve Can Help the Recession

Principles of Macroeconomics

How the Federal Reserve Can Help the Recession The economy is one of the most important factors that affects every person and all the organizations in the United States. Since the 1970s, the United States has suffered four recessions and two high inflations. Some people feel that less involvement from the government will decrease bad performance and possibly the economy would be better off. Others individuals feel that the government should be more involved to prevent serious issues such as the current recession. If the Federal Reserve (Fed) was keeping a careful eye on the commercials banks and the major corporations such as American International Group, perhaps some of these current issues could have been avoided. One of the most important things to keep in mind is to forget the “what ifs” and to focus on the process of economic growth. The Fed has three important tools that can potentially influence the economy out of a recession. This paper will talk about these three tools: the power to change the discount rate, reserve ratio, and dealing with open market operations. The Federal Reserve System is the United States’ central bank. Americans can not open an account with the Fed. American can open bank accounts with Bank of America, Citizens Bank, and Bank United which are known as commercial banks. These commercial banks have an account with the Federal Reserve Bank and the opportunity to take out loans with the Federal Reserve Bank. Some commercial banks are hesitated to take out loans from the Federal Reserve Banks because of the high discount rate. This fear makes commercial banks more inclined to take out loans from the private market. In the past, the Fed would use moral suasion to discourage commercial banks from borrowing too much from the Federal Reserve Bank. Now times are different and since January 9, 2003, “the Fed announced a new procedure. Henceforth, the discount rate would be set above the rate that banks pay to borrow money in the private market and moral suasion would no longer be used. Although banks can now borrow from the Fed if they want to, they are unlikely to do so except in unusual circumstances because borrowing is cheaper in the private market” (Case, Foster, & Oster, 2009). If commercial banks can increase their borrowing from the Fed, it will increase the money supply. Increase in the money supply allows the opportunity for commercial banks to give out more loans to people who may want to go to college, start a small business or franchise, or to buy a house which in turn will stimulate the economy. It is also important for the Fed to ensure that the discount rate is not too high or too low. If interest rates from commercial banks are too high for individuals to pay back in a timely fashion then customers may have trouble paying it back or worse file for bankruptcy. So it important that the discount rate is in a reasonable state where it can help fight recession but not cause potential issues in the future. Federal Reserve can also use the reserve ratio tool, which can help increase the money supply. The Fed sets a certain ratio that all banks must abide to. A certain amount of money must be reserved by all banks, in other words “if a bank has $10 million in deposits, and $1.5 million of those are currently in the bank, then the bank has a reserve ratio of 15%. In most countries banks are required to keep a minimum percentage of deposits on hand, known as the required reserve ratio. This required reserve ratio is put into place to ensure that banks do not run out of cash on hand to meet the demand for withdrawals” (Moffatt, 2011). By decreasing the reserve ratio it gives banks the chance to use the extra cash flow and “allow banks to have more deposits with the existing volume of reserves. As banks create more deposits by making loans, the supply of money (currency + deposits) increases” (Case, Foster, & Oster, 2009). As soon as the economy starts to improve the reserve ratio can be increased to prevent inflation. This tool can be another key in helping increasing the money supply, but it can also be a tricky and dangerous one if not used correctly. Open market operations are another tool the Fed can use to help the economy out of a recession. The Fed has the option to sell or buy their securities in an open market. In other words if the average American wants to buy securities from the government they have the option to do so, we know these as bills and bonds. The way these securities can help the economy get out of a recession is that the Fed purchases these securities to help increase the supply of money; “An open market purchase of securities by the Fed results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves” (Case, Foster, & Oster, 2009). In other words it is time for Fed to buy back all the government securities to help increase the supply of money. Once we have accomplished steady economic growth, the Fed can sale securities to help decrease the supply of money to prevent inflation. Thankfully, this tool is a lot more flexible than discount rate and reserve ratio. The Federal Reserve has these three tools that can potentially influence: the economy out of a recession, the power to change the discount rate, reserve ratio, and dealing with open market operations. These tools can help the economy get out of the recession but with everything in life it must be in done in a balanced matter. It is also important to remember that Federal Reserve can not do things without the permission of the Congress. Hopefully, with intelligence of the congress, employees of the Federal Reserve and Americans Citizens we can get through these hard times. References
Case, K.E., Fair, R.C., and Oster, S.E. (2009). Principles of Macroeconomics. (9th ed). Upper Saddle River, New Jersey: Pearson Prentice Hall.

Moffatt, M. (n.d.). A beginner 's guide to the reserve ratio. Retrieved from http://economics.about.com/cs/money/a/reserve_ratio.htm

References: Case, K.E., Fair, R.C., and Oster, S.E. (2009). Principles of Macroeconomics. (9th ed). Upper Saddle River, New Jersey: Pearson Prentice Hall. Moffatt, M. (n.d.). A beginner 's guide to the reserve ratio. Retrieved from http://economics.about.com/cs/money/a/reserve_ratio.htm