Federal Reserve System

Federal Reserve System: Monetary Policy

The Federal Reserve System is the central banking system of the United States. The Federal Reserve was created in 1913, as part of the Federal Reserve Act. Although its duties has changed and evolved since its creation, the Federal Reserve has a clear and important role in the economy of the United States. The Federal Reserve’s official responsibilities are to conduct the monetary policy, regulate banking institutions, and maintain the stability of the financial system. The Federal Open Market Committee controls the monetary policy, in an attempt to control the money supply and affect the interest rates. To understand how this committee implements policy, the remainder of this paper will discuss tools they use to control the money supply and how it can affect interest rates.

The first major tool the FOMC has is making adjustments to the reserve requirement. The reserve requirement is the ratio of deposits to the total amount of money loaned out. When the FOMC increases the reserve requirement it will decrease the amount of loanable money financial institutions have. This will put upward pressure on interest rates and discourages borrowing. This scenario could take place in order to lessen spending in a time of increased inflation. If the FOMC decreases the reserve requirement they are essentially trying to put more money into the economy by increasing loanable funds. A decrease in the requirement would lower interest rates and encourage spending in a slow economy.

Another tool the FOMC can utilize involves open-market operations. The FOMC can buy or sell government securities through the Fed Trading Desk. When the FOMC sells securities it pulls money out of financial institutions and into the Federal Reserve, where it is out of circulation. This act will decrease an institution’s ability to loan funds. Once again, less loanable funds will tighten lending practices and drive up interest rates. If the FOMC buys securities, they are injecting additional funds into the institution. The amount of loanable funds will then increase. Due to the loosening of lending practices interest rates will decrease to encourage borrowing.

The third and final tool that I will discuss is the discount rate. The discount rate is the interest rate banks and other financial institutions are charged when they borrow money from their regional Federal Reserve Bank. Institutions that are eligible for the primary credit program are usually loaned funds on a short term basis, usually overnight. For those who do not qualify, secondary credit is also available. During times of inflation, the discount rate may be increased to reduce the availability of money. The opposite is also true. When the discount rate is decreased, there is downward pressure on interest rates. Banks will have more funds to loan, which encourages investors to borrow.

When all three tools are simultaneously used it is clear how the Fed can control the money supply and implement its monetary policy. Any change in either of these tools will have an effect on financial institutions as well as the borrowers who go to them seeking loans. Our book mentions these three tools briefly, but never explains in much detail how they affect the real estate industry. When the money supply is tight loans become harder to obtain. Thus, many people will be unable to finance the sale of a home. This will cause the effective demand to decrease, which in turn drives home prices down. Of course, many other factors need to be considered to get a broader understanding of real estate prices and the appraisal process. However, having knowledge of the Federal Reserve System’s monetary policy is a valuable tool for any real estate appraiser.

Madura, Jeff. Financial Markets and Institutions. Mason, OH: South-Western Centage Learning, 2010. Print.

McKenzie, Dennis J., and Richard M. Betts. Essentials of Real Estate Economics. Mason, OH: Thomson/South-Western, 2006. Print.

Rattermann, Mark. The Student Handbook to the Appraisal of Real Estate. Chicago, IL: Appraisal Institute, 2009. Print.