For most people, the word ‘economy’ brings the same few things to mind: money, Alan Greenspan, banks, and – more recently – home mortgages. And while the field of economics is much broader than government-related finance, this is the area that the media is most concerned with.

The Federal Reserve System has the most influence on the way money works around you. It works to influence bank transactions and consumer spending all while aiming to keep prices and employment at stable levels. After all, it’s hard to juggle your personal finances when the inflation rate is 231 million percent, as it was in Zimbabwe in July 2008 (inflation in the U.S. is usually around three or four percent).

In order to better discuss how these institutions affect you, however, a solid foundation of knowledge is needed, so we put together this study guide on the Federal Reserve, with questions taken from people like you, who stand outside the ivory tower that only economists and financial experts seem to inhabit.

With these answers as a reference, you should be able to comfortably listen to almost all econ-talk in the news without feeling entirely lost. And so we begin:

What is the Federal Reserve System?

The Federal Reserve System is the central banking system of the United States. The role of a central bank is to serve as the “lender of last resort” to banks.

The U.S. central banking system is a little more complex than other countries’ because it is not jut one bank: there are twelve regional banks across the country that confer with a Board of Governors to make decisions on monetary policy. This group (Governors + regional bank presidents) is called the Federal Open Market Committee (FOMC), commonly referred to simply as “the Fed.”

What does it mean to be a “lender of last resort?”

The way private banks make money is by giving loans for a certain dollar amount, then charging interest on payment. For instance, you buy a house for 100,000 dollars, and the bank charges you five percent interest. This means you pay the bank five percent more than that 100,000, or 105,000 dollars. That 5,000 dollars is bank profit.

The central bank works the same way, only instead of giving out home and car loans, it gives out loans to those private banks.

But why would those private banks need loans? Well, at the end of the day, after all the lending, U.S. banks are required to have ten percent of all their customers’ deposits hand. If they don’t, they can borrow it from other banks or the Federal Reserve. The Federal Reserve is the last resort, lending to those who can’t find loans elsewhere – which usually takes place when a bank is in financial trouble – thereby holding off Great Depression-style bank panics and protecting customers (which it didn’t do well in 1929, a contributing factor to the depth of the Depression). The interest that the borrowing bank has to pay back is determined by the federal funds rate.

What does the federal funds rate mean? How does it affect me as a consumer and the economy at large?

When you’re watching the news and they say that the Fed has raised or lowered interest rates, what they actually mean is that the FOMC set a new target federal funds rate. By doing so, they are influencing other interest rates throughout the economy. For example, as the stock market was crashing last fall, the number of home loans given out dropped dramatically. In an effort to influence people to take out loans, the Fed lowered the targeted federal funds rate. Normally this captures the “on-the-fence” type of people, who are seriously thinking about upgrading to a nicer house or a newer car; the money saved thanks to a lower interest rate would make the investment worth it. By triggering consumer spending and investment, the hope is that the economy will be able to continue to grow.

Of course, if the role as lender of last resort and setter of interest rates were the only functions the Fed served, we would have stopped discussing them on such a broad level shortly after the bank failures dropped out of the headlines.

On Tuesday, part two in this series will discuss how the Federal Reserve works to keep prices stable, GDP growing and unemployment low.

Popularity: 2% [?]