One of the principal ways in which the Fed provides insurance against financial panics is to act as the "lender of last resort", one of the tools used recently as the subprime mortgage debacle led to a credit crunch in the summer of 2007. When business prospects made commercial banks hesitant to extend credit, the Fed stepped in by lending money to the banks, thereby inducing banks to lend more money to their customers. The Federal Reserve does this by lending at the Discount window and changing the discount rate. The federal funds rate is the interest rate that banks charge each other.

The federal funds rate target is decided at Federal Open Market Committee (FOMC) meetings. Depending on their agenda and the economic conditions of the U.S., the FOMC members will either increase, decrease, or leave the rate unchanged. It is possible to infer the market expectations of the FOMC decisions at future meetings from the Chicago Board of Trade (CBOT) Fed Funds futures contracts, and these probabilities are widely reported in the financial media.

The Federal Reserve’s open-market operations consist of the buying and selling of government securities by the Fed. If the Fed buys back issued securities (such as Treasury bills) from large banks and securities dealers, it increases the money supply in the hands of the public. The Fed can decrease the supply of money when it sells a security. The monetary expansion following an open-market operation involves adjustments by banks and the public. When the Fed buys securities from a member bank, the bank's reserves increase, thereby encouraging it to lend . When the bank makes an additional loan, the person receiving the loan gets a bank deposit. These actions cause the money supply to increase by more than the amount of the open-market operation. This multiple expansion of the money supply is called the money multiplier.

Today, the Fed uses its tools to control the supply of money to help stabilize the economy. When the economy is slumping, the Fed increases the supply of money to spur growth. Conversely, when inflation is threatening, the Fed reduces the risk by shrinking the supply. While the Fed's mission of "lender of last resort" is still important, the Fed's role in managing the economy has expanded since its origin. As we near the end of the first quarter of 2008, the Fed has been lowering interest rates because the threat to growth has taken precedence over the Fed’s concern about inflation. Therefore, at this juncture, the Fed is working to keep the economy out of recession and attempting a “soft landing”.

About the Author:

John Kaighn is an Investment Advisor Representative with Jersey Benefits Advisors and writes articles about business and financial matters. For more information, visit http://jerseybenefits.com or http://johnkaighn.com