Macroeconomics

The Federal Reserve (the Fed) is the central bank of the United States. The Fed regulates and
oversees the nation’s commercial banks by ensuring that banks have enough money in reserve
to avoid bank runs. A bank run happens when many people withdraw their money from a
bank at the same time because they think the bank will fail. The bank cannot provide the
amount of money that is requested.

The Fed also conducts monetary policy. It increases or decreases the money supply to speed up
or slow down the economy. The Fed manipulates interest rates by changing the money supply.
When interest rates are low, it is easier to pay back loans, so consumers borrow more and spend
more. Consumers borrow less and spend less when interest rates are high.

The Fed loans money to banks with interest that is set at a discount rate. The lower the rate,
the more banks will borrow and the more money will go into circulation. Consumer banks set
the interest rates they charge slightly higher than the Fed’s rate. Therefore, the Fed determines
interest rates in the economy.

The Fed can also increase or decrease the total supply of money through open market
operations (OMO). This tool, applied to bonds of all maturities, allows the Fed to buy and sell
Treasury bonds in the open market. Because an OMO changes the total supply of money,
interest rates are affected.

If the Fed buys bonds from consumers, it increases the money supply in the economy by
removing bonds in exchange for cash. Prices are pushed higher, and interest rates decrease.

If the Fed sells bonds to consumers, it decreases the money supply in the economy by removing
cash in exchange for bonds. Prices are pushed down, and interest rates increase.

The Federal Reserve

• is an independent entity;
• is subject to little government regulation;
• has a board of governors and chairperson that are not elected; and
• is organized to remain independent and insulated from politics.

Government and central banks put a stabilization policy into place to keep price levels, unemployment, and economic growth stable. Monetary and fiscal policy can stabilize demand and, therefore, production and employment. A fiscal policy can lower disposable income—and thus demand—with a tax increase. A tax decrease boosts demand by increasing disposable income.