The Federal Reserve System Essay

a. Define the purpose and function of money

Money has three purposes in the economy:

First, it is a medium of exchange in economic transactions, by which one party compensates for the other’s goods or services, instead of traditional means such as barter and gold.

Second, individuals can store value in money instead of physical assets. When money is saved, it can be used for future transactions and be exchanged against goods or services that are not needed at the moment.

Third, money is a measurement unit for accounting purposes. That is, since money represents value, the worth of any asset of liability can be stated in money value. This function is essential for understanding the economic significance of an item, either tangible (e.g. machine) or intangible (e.g. goodwill). Another important use of money in this context is the ability to plan budgets and to understand the economic meaning of a business process.

When looking at the whole economy, it is clear that only a fraction of the total money in a given economy represents physical holdings of money. Instead, money has several major forms:

  1. Narrow or Transaction Money: also known as M1 or monetary base. These are paper money, coins and bank chequing deposits (sight deposits)
  2. Near or Broad Money (M2): very close substitute for narrow money, such as saving accounts in banks.
  3. Deposits: Banks can create money by issuing promises to pay, which exceed the bank’s real money holding and reserves. The sum of all cash, near cash and deposits in a given economy is defined as the nation’s total money supply.

b. Explain how the central bank manages a nation’s monetary system.

The general role of the central bank is to control the country’s money supply, and by that to improve price stability, to keep unemployment low and to encourage high GDP growth. The essence of the bank, very basically speaking, is to ensure the government’s debt and to regulate commercial banks so that they will have enough liquidity.

The central bank has three main instruments: (Arnone, Laurens, Segalotto & Sommer, 2008)

  1. Discount (interest) Rate: setting the benefit commercial banks can have from lending money to the central bank (government bonds). In general, the higher the discount rate, the higher the incentive to save and thus the lower the propensity (and thus the ability) to spend.
  2. Open-Market Operations: the central bank can influence the money markets through trading in high volumes.
  3. Standards for Required Reserves: commercial banks are obliged to keep a minimum portion of their deposits (i.e. their promises to pay) in the central bank. Since deposits in the central bank are accounted as part of the cash-base (high-powered money), the standards for required reserves set the ratio between cash-base and the total money supply of an economy.

c. Outline the stated direction of recent monetary policy in the US.

Referring to the three major monetary policy instruments mentioned earlier (interest, open-market operations and requirement for deposits), the Federal Reserve’s February 2009 report includes several key policies in response for the recent global economic trends: (Board of Governors of the Federal Reserve System, 2009)

First, the general risk in the US market has been significantly increased since the summer of 2007; the Federal Reserve intends to encourage economic activities by lowering the interest rate on the US dollar to a target of 0-0.25%. The goal is to compensate for the general risk by making retail credit cheaper, and thus to decrease the risk in economic decisions and to ease the access for finance.

Second, the Federal Reserve raised its level of influence on the market to exercise its role to guarantee the stability of the US financial sector. The main aim of the Federal Reserve’s open-market was to secure existing liabilities in the money markets. These include, among others, securing mortgages, backing-up bonds and providing liquidity to collapsing financial institutions such as insurance company American International Group (AIG) and Citybank, mainly by direct purchasing of shares and providing low-interest loans.

d. List at least one policy action that the Federal Reserve has taken to confirm that direction.

In addition to the actions briefly mentioned earlier, one representative example is the decision to create a lending facility as part of the Federal Reserve Bank of New York. Since March 17, 2008 and until October 30, 2009, the so-called Primary Dealer Credit Facility is authorized to provide financing to participants in securitization markets.

e. Explain the effects of monetary policies on the economy’s production and employment

The main elements economic system, namely output (Real national income and GDP), employment and inflation, are largely influenced by the Macroeconomic Equilibrium. The latter term refers to the point of quality between an economy’s Aggregate Demand (AD) and its Aggregate Supply.

AD and AS are made up from the trends in market for goods and services and in the market for money; whereas the goods markets follow the patterns of expenditure of public and private markets, the money market is naturally influenced from money supply. The central bank has a decisional role in adjusting the money supply, which, as mentioned earlier, is made up from cash-base and deposits, both are under tight control of the bank.

For example, in order to stimulate the economic activity (which should result in higher GDP and employment), the central bank can increase the amount of money by lowering the interest rate. This should result in lower discount rates for credit and lower attractiveness of financial investment activities, hence to bring about more investments in the market for goods and services. Hence, the bank’s main instrument, the ability to determine interest rates, serves in all attempts to influence the economic structure.


  • Arnone, M., Laurens, B.J., Segalotto, J.F. & Sommer, M. (2008, September 23). Central Bank Autonomy: Lessons from Global Trends. Retrieved May 6, 2009 from
  • Board of Governors of the Federal Reserve System. (2009, February 24). Monetary Policy Report to the Congress. Retrieved May 5, 2009 from