Some of the rest of the Washington Post article, SI won't let me post the whole thing, too long I guess:
The Federal Reserve cannot put a dollar in anyone's pocket, provide jobs for very many people or buy more than a tiny amount of goods and services that the nation produces.
But the 86-year-old government bank can have an enormous impact on how you spend, invest or borrow money, as well as the number of your neighbors employed.
That is because the Fed, as nearly everyone calls it, is in charge of the nation's monetary policy, taking actions almost daily to help determine how much money is available, how easily it may be borrowed and how costly it will be. That in turn affects how many people will have a job, whether prices will be stable and how many goods and services will be produced and sold.
As the late Lester V. Chandler, an economics professor, once observed, you don't have to be an economist to know the importance of money -- which, at its most basic, means cash and deposits in checking accounts.
People with more money than they require can save it and lend it to people or businesses who need it to buy costly items such as houses, cars, factories or airplanes. That's why people talk about money and credit (loans) in the same breath: What to a bank is a loan is to a borrower money to spend.
There are times when money is difficult to obtain, loans become expensive and individuals and businesses don't spend. People lose jobs because such items as cars and airline tickets are not purchased or new buildings are not built.
At other times, lots of people have jobs, money seems easy to obtain and people and businesses spend freely. Sometimes, the good times get out of hand. Too many dollars chase too few goods, and prices rise. Loans can be obtained so easily that free spending becomes frivolous spending as investors pay too much for assets such real estate and stocks.
Monetary policy seeks to guide the economy between these extremes.
With an eye on today and tomorrow, the Fed regulates the supply of credit and money. It tries to make sure that dollars are plentiful enough so consumers and businesses can buy all of the goods and services produced by the economy, even while investing in new facilities and technology to supply a growing population and provide a higher standard of living.
The Fed does not work directly on consumers or businesses but accomplishes its policy through banks. When it changes monetary policy, it manipulates the amount of funds that banks have available to lend, using as a guide the interest rate on funds that banks lend to each other.
The ultimate aim of these manipulations is to change what economists call "demand" -- the amount of goods and services that consumers and businesses are willing and able to buy. Sometimes, policy makers want them to buy more, other times less. Sometimes, the Fed is happy with the way things are.
If not enough money is available and loans are expensive and hard to obtain, people spend less. Businesses then produce fewer goods and services than they are capable of producing. They lay off workers and slow investments. If production declines for many months, in what is called a recession, many people can lose jobs.
Alternatively, if too much money is available, the major consequence is inflation -- a general increase in prices. If businesses are near the limit of their production capacity, any increase in the money supply means that consumers and businesses will spend more dollars on the same amount of goods and services, driving up their average cost.
Inflation strikes especially hard at those on fixed incomes (such as retirees) or whose incomes do not rise as fast as inflation (often poor people). It also hurts those who save and lend because their dollars may be worth less in the future.
The Fed's job involves being alert for signs of recession or accelerating inflation and conducting monetary policy aimed at preventing either. A 12-member group, the Federal Open Market Committee (FOMC), meets eight times a year to review the economy and monetary policy. In 1978, Congress ordered it to conduct policy to achieve twin goals: price stability and full employment.
When FOMC members determine that demand for goods and services is increasing faster than businesses can supply them, they tighten monetary policy to fight inflation. The panel does this by reducing funds available to banks for loans and by raising interest rates to make businesses and consumers less willing to borrow and buy.
If businesses aren't selling as many goods and services as they can produce and fewer people have jobs than want them, or if the Fed thinks that the economy is headed in that direction, it eases policy. It lowers interest rates by increasing the funds that banks can lend, hoping to encourage businesses and consumers to buy more.
Still, the Fed cannot make people spend or borrow more than they want to, and it cannot force banks and other lenders provide loans. Even its control over interest rates is limited -- very powerful on short-term loans, much less so on long-term loans such as home mortgages.
The Fed can only change the level of bank reserves in a way that it thinks will provide the amount of money and credit that will lead to full employment, stable prices and economic growth.
Moreover, monetary policy does not address important economic issues, including growing income inequality, what particular goods and services consumers want to buy and what investments businesses are willing to make.
Moving the Market
Over the years, the Fed has used three tools to conduct monetary policy -- the discount rate, reserve requiremements and so-called open market operations.
The discount rate. Banks that borrow from the Fed are charged this interest rate. A bank can increase funds available to lend by borrowing from the Fed at the so-called discount window. Decades ago, this was a key tool of monetary policy. The Fed raised or lowered the discount rate when it wanted to change bank lending. [See chart below.]
But the discount rate is a passive tool. For it to work, banks must come to the Fed to borrow. For about 15 years, healthy banks have virtually ceased borrowing at the discount window, so the Fed cannot affect lending much by raising or lowering the discount rate.
Reserve requirements. The Fed requires commercial banks and other deposit-taking institutions such as savings and loan associations to keep a percentage of checking deposits on "reserve" as cash in their vaults or as deposits in special "reserve balance" Fed accounts that resemble standard checking accounts.
A bank cannot lend required reserves. So the Fed can induce banks to lend more or less by changing the reserve requirement. If the Fed raises the requirement, say from 10 percent (as it is for most large banks today) to 11 percent, banks would have 1 percent less of their checking deposits available to lend. If the requirement is lowered, funds would be freed.
Because banks earn no interest on reserve deposits, they prefer to keep them close to the required minimum. Those holding more than is required lend the excess, usually overnight, to banks that are short of reserves and otherwise would pay a sizable penalty to the Fed. The interest rate paid by a bank to borrow excess reserves from another bank is called the federal funds rate. It is determined by supply and demand.
As with the discount rate, the Fed seldom changes reserve requirements to affect monetary policy, The Fed adjusts reserves regularly. Not only would frequent changes in reserve requirements often be disruptive to banks, but they also would be likely to change reserves in far bigger increments than the Fed usually seeks.
Open market operations. The Fed currently carries out monetary policy almost exclusively by buying and selling government securities from private sources.
The New York Federal Reserve Bank is one of the 12 regional banks [see box above] and is the main actor. Securities that it buys and sells are basically IOUs issued by the federal government for various periods of time as Treasury bills, notes and bonds. [See box on facing page.]
The government owes about $3.75 trillion, and on an average day, investors buy and sell about $150 billion of its bills, notes and bonds in so-called government securities markets.
The Fed relies on those markets to carry out monetary policy for two basic reasons: With $150 billion in daily trading, the Fed almost always finds buyers and sellers easily, and although individual trades can amount to several billion dollars, they still are small enough to have little impact on government securities prices.
The New York Fed open market desk does business with securities firms, called dealers, which are in business to trade Treasury securities for customers and themselves. The Fed designates about 30 of them as "primary dealers, and those are the firms with which the Fed buys and sells securities.
When the Fed buys securities, it pays by making a deposit to the "reserve" account of the primary dealer's bank. That increases the bank's reserves and therefore the amount of money it can lend. If the Fed sells securities to a dealer, it charges the reserve account of the dealer's bank.
In that way, the Fed can control the amount of reserves in the banking system -- adding to them by purchasing securities, reducing them by selling securities.
Multiplying Money
Because banks lend and relend deposits, the dollar value of any monetary policy action can greatly exceed the value of the initial deposit. That relending is how the banking system creates money.
For example, if the Fed buys $1,000 of government securities, it pays by depositing $1,000 in the Fed account maintained by the bank where the primary dealer does business.
That bank's deposits increase by $1,000. If the reserve requirement is the 10 percent typical for banks of any size, the bank must keep $100 on reserve and can lend $900.
The loan is money to the borrower, who writes a check for $900. The recipient of the check deposits it in his bank, whose deposits increase by $900. That bank sets aside $90 on reserve and can lend $810. At this point, the initial $1,000 Fed deposit has resulted in $2,710 of total deposits.
Although no individual bank does anything but accept a deposit, set aside part of it and lend the rest, the banking system multiplies the initial deposit manyfold. The amount of money the banking system can create from a deposit ultimately is limited by the reserve requirement. The higher the requirement, the less money can be created.
When a bank bases a loan on savings deposits, it theoretically is not bound by reserve requirements and could lend 100 percent of a deposit. In reality, because of the risk that any loan will not be repaid, banks prudentially set aside some portion of deposits to meet customer requirements and to invest in safer ways such as in Treasury bills.
When the Fed sells securities, the reverse process occurs. In payment for the securities, the Fed takes reserves from the dealer's bank. That bank then has less money to support loans and must reduce lending. With the ripple effect, available money and outstanding credit declines many times more than the amount that the Fed reduced bank reserves.
In real life, money and credit seldom expand or contract by the amount theoretically possible. Monetary policy changes seek mainly to push money and credit in a specific direction. Consumers, businesses, borrowers and lenders make the actual decisions.
Over the years, the Fed has used many guideposts to determine whether banks are being given an amount of reserves that it thinks will induce consumers and businesses to make decisions it wants them to make. Today, the FOMC picks a federal funds rate that it thinks will produce a level of reserves compatible with its monetary policy goals of full employment and price stability.
Explained in the most basic way, if the federal funds rate rises above the target, the New York Fed adds reserves by buying securities. If not, it sops up reserves. [See story on facing page].
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