The Federal Reserve System has the ability to greatly influence the banking system and even the American economy in ways that many Americans may not understand. The influences, or monetary policy, caused by the Federal Reserve can have many desired results like lowering interest rates that in turn allow Americans to take out loans at a lower cost. The Federal Reserve can even manipulate the money supply itself. Ultimately, the Federal Reserve allows banks to lend these deposits in the form of loans and only requires a "fraction" of their total deposits to be kept at the Federal Reserve or inside the bank's vault. The greater the reserve requirements imposed by the Federal Reserve results in a decrease in the overall money supply and less money for individuals that need loans.
In short, the Federal Reserve is the central bank of America. It controls and regulates how banks in America do business. The Federal Reserve requires banks to keep a minimum amount of deposits within the bank at all times, while the rest may be used to purchase low risk securities or even to be loaned out. An important fact to know is that banks are unique in that they actually earn their profits from liabilities that are kept in the form of demand deposits. When a bank customer deposits money in their bank account, these funds are an asset for the depositor but a liability for the bank because the bank must give this money back anytime the customer wishes to make a withdrawal. Yet, these liabilities are actually the means to which banks earn their profits. This is an important reason for having a central bank oversee how banks use deposits because banks are very vital not only for the financial sector but the economy as a whole. If depositors could not receive their withdrawals in a timely way, or even at all, they would not have any use for utilizing banking services.
The Federal Reserve is structured by a seven member Board of Governors and each governor serves a single fourteen year terms. The Board of Governors are appointed by the President and confirmed by Congress. Geographically, the Federal Reserve is broken down in twelve districts. For instance, District 6 oversees banking operations in Florida, Alabama, Louisiana, Georgia, and Parts of Mississippi and Tennessee, and has headquarters in Atlanta. There are different components of the Federal Reserve for handling different aspects of monetary policy. The Federal Open Market Committee oversees the nation's open market operations. Specifically, the Federal Open Market Committee (FOMC) oversees the buying and selling of United States Treasury securities. Simply put, if the FOMC senses that measures need to be taken for increasing the money supply, authorization would be given for purchasing Treasure Securities that are already on the market. Take for instance; if a bank sold its Treasury securities that it has on hand, the result would be added funds for that bank to loan to potential borrowers. On the other hand, selling securities on the open market actually decreases the money supply. Also, banks borrow from other banks to meet their reserve requirements, as established by the Federal Reserve. Many times banks will borrow from other banks, to ensure that their reserve requirements are met. Of course there is a fee for borrowing from another bank, this fee is in the form of an interest rate and is called the Federal Funds Rate. The Federal Reserve has the ability to lower the rate banks borrow from other banks, by doing this the Federal Reserve can help increase the money supply because banks, just like regular individuals, will borrow money at lower rates. These banks can then lend funds out to potential borrowers.
The actual Minutes for the last Federal Open Market Committee meeting on September 21, 2011 gave a "directive" for the Federal Reserve Bank of New York to purchase, by the end of June 2012, Treasury securities with remaining maturities of nearly 6 to 30 years with a total face value of $400 billion, and to sell Treasury securities with remaining maturities of 3 years or less with a total face value of $400 billion. The goal of this decision is to increase economic activity by lowering long term interest rates. If long term interest rates are lowered, consumers will likely take out more loans, thus, increasing home sales. The Minutes from this meeting appear to show the collective mindset of the FOMC that something needs to be done to increase housing sales. Obviously, the Federal Reserve is powerful, and can control many aspects of the economy; perhaps it can even enact policies to manipulate the whole economy. GDP could possibly increase as a positive affect of selling the short term securities and buying the long term securities because the lower interest rates go, the more likely consumers will be willing to purchase goods. This would likely keep price levels stable, and increase employment opportunities since this would likely increase construction of homes. Perhaps the sales of other goods like automobiles will increase due to the fact that consumers will be willing to purchase these items with the added incentive of lower interest rates.
The actions of the Federal Reserve can have many affects on the well being of the American economy by controlling interest rates. The Social Discount Rate (SDR) is the interest rate that is used to do cost benefit analysis for public goods. Developing countries use higher Social Discount Rates while in America; the Environmental Protection Agency typically uses a Discount Rate of 7 percent. The process of discounting is actually very simple. Financiers live by the rule, "A dollar today is worth more than a dollar tomorrow." Looking deeper into this axiom think about the Florida Lottery System and how the installments would be paid out to a potential winner. The following formula can be manipulated to solve for the Present Value (PV) or even the Future Value (FV) of a potential cash flow, FV=PV (1+i)n. The other variables in this formula are 'i' and 'n', which stand for interest rate and the number of terms being compounded. For a simple example of how this formula works, simply substitute the value of '1' into the value of 'n' and for the PV as well. Also, use the value of 0.1 for the interest rate. The Future Value resulting from this example will be 1.1. This means is that if $1 were invested for a period of one year at an interest rate of ten percent, the value of this investment would be $1.10 at the end of the year. Now on the other hand, solving for the Present Value of an investment is simple as well. Manipulating the above formula for Present Value results in, Present Value= Future Value/(1+i)n. This time, substitute '1' for the Future Value and 'n'. Also, use 0.10 for in the interest rate. The result will be 0.909. In reality, this means that the value of $1 in one year is actually worth $0.91 dollars today. So, say you won the Florida Lottery, and were paid $3 million to be paid out in $1 million installments for the next three years. Also, assume that a discount rate of ten percent. The Present Value of these cash flows would be illustrated as below if the first payment were to be paid one year from now:
Year 1 = 1,000,000/(1.1)1= $909,090.91
Year 2 = 1,000,000 /(1.1)2= $826,446.28
Year 3 = 1,000,000 /(1.1)3= $751,314.80
The Present Value of these cash flows would be illustrated as below if the first payment were to be paid now:
Year 1 = 1,000,000
Year 2 = 1,000,000 /(1.1)1= $ 909,090.91
Year 3 = 1,000,000 /(1.1)2= $ 826,446.28
The Total Present Value would simply be the sum of these three payouts, which would be $2,486,851.99 if the first installment were to be paid one year after the winner was determined or $2,735,537.19 if the first installment were to be paid now. In other words, the Florida Lottery is actually costing lottery winners money by not paying their complete winnings upfront.
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