The Federal Reserve System

Transcription

1 Question 1: What is the Federal Reserve System, and how is it structured? Answer 1: The Federal Reserve System serves as the central bank of the United States. It operates under the auspices of the federal government and yet maintains a somewhat independent character. The Federal Reserve dates back to December 1913 and addresses the need for a single unified policy to manage currency in the economy (The Federal Reserve Board, n.d.). Prior to the establishment of the Federal Reserve, it was typical to see foreign currency used throughout the country. In particular, Spanish gold pieces of eight were used frequently for commerce. The Federal Reserve System has a central Board of Governors in Washington, DC and 12 member banks located throughout the country. Many of the member banks are located in the eastern half of the country because at the time of the Fed s founding, the western half of the country was sparsely populated. For example, the Federal Reserve Bank of San Francisco has jurisdiction over 12 states while the Federal Reserve Bank of Philadelphia presides over only the State of Delaware and parts of Pennsylvania and New Jersey (The Federal Reserve Board, n.d.). Question 2: What are the four main functions of the Federal Reserve? Answer 2: The Federal Reserve has four main areas of responsibility. The first is the conduct of monetary policy, which means managing the credit markets and money supply. The Fed (which is another name for the Federal Reserve) is charged with the responsibility of maintaining high levels of employment and moderate prices. The second is supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers (The Federal Reserve Board, n.d.). In other words, the Federal Reserve sets the overall regulations to which commercial banks must adhere and make sure that the banks carefully follow the rules. The third area addresses stability in the banking system. When there is a shock to the economy, meaning that there is some unexpected event, the Federal Reserve will step in to ensure that banks remain open and credit is available. Lastly, the Fed plays an operational role within the banking system by providing services to the Federal Government and facilitating payments mechanisms between banks. On a basic level, this means that the Fed organizes the way banks send money to each other. 1

2 Question 3: What are open market operations? Answer 3: The Federal Reserve has three broad tools it can use to manage the overall economy. The first is called open market operations, which involve the buying and selling of U.S. government debt. When the government spends more than it takes in taxes, it must borrow it by issuing bonds. The Federal Reserve then regulates the supply of money in the economy by buying and selling these bonds. When the Fed purchases bonds, it sends money to banks and individuals in exchange for the bonds. This pumps more money into the economy and increases the money supply. When the Fed sells bonds from its inventory, it collects money from the individuals and banks to purchase those bonds. This then removes the money from the available money supply because it remains in the central bank and does not circulate (The Federal Reserve Board, n.d.). As a tool, open market operations are particularly flexible because the Fed can buy and sell securities on a daily basis. As significant changes happen in the economy, the Fed can be quick to respond. The overall goal of open market operations is to maintain a stable interest rate and inflation level by manipulating the supply of money in the economy. When the Fed removes money from the economy, this can cause interest rates to rise. When the Fed pumps money into the economy, interest rates fall. Question 4: What is the discount rate? Answer 4: Commercial banks maintain balance sheets of deposits and loans. Sometimes a bank may find that it needs a short-term loan to cover some liability, usually to another bank. The Federal Reserve will step in and loan a commercial bank the money it needs to cover this short-term liability. However, this loan comes at a cost, known as the discount rate, which is simply the interest rate a commercial bank must pay the Federal Reserve to borrow money overnight. The Federal Reserve serves as the lender of last resort to commercial banks that need temporary loans. Ideally, a commercial bank should balance its books carefully and not need the regular assistance of the Fed. If a commercial bank is in chronic need of loans from the Federal Reserve, a greater regulatory issue may exist. The Fed also uses the discount rate as a way to manage short-term interest rates in the economy. If the Fed wishes to stimulate the economy and cause 2

3 economic growth, it will maintain a very low discount rate. For example, soon after the attacks of September 11th, the discount rate fell to historic lows of 1% (The Federal Reserve Board, n.d.). If the economy overheats, the Federal Reserve can raise the discount rate. When the cost of credit is higher, banks and consumers are less likely to borrow money; this in turn will slow the economy. Question 5: What are reserve requirements? Answer 5: When a consumer makes a deposit into a bank, this creates a liability for the bank because it owes those consumers their money plus some interest. Banks then loan out those deposits to other customers or businesses and collect interest on those loans. The difference between the interest rate for loans and deposits is called the spread. The bank makes money based on the spread. The U.S. banking system operates on a fractional reserve system. For example, the bank may take in $1 million in deposits and then loan out $900,000 of that. In this sense, the bank only maintains a fraction of the deposits to return to depositors at any given time. According to the Federal Reserve, Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities (The Federal Reserve Board, n.d.). The Fed regulates what percentage of deposits can be loaned out. For very small institutions with deposit accounts of less than 8.5 million dollars, the reserve requirement is 0%. For medium-sized institutions with more than $8.5 million to $45.8 million in deposit accounts, the reserve requirement is 3%. For institutions larger than this, the reserve requirement is 10% (The Federal Reserve Board, n.d.). Question 6: How does Social Security work? Answer 6: Social Security is an official Federal Government program that was developed to help combat poverty within the elderly and disabled populations. The government funds Social Security primarily through a payroll tax. The current tax is 12.4% on each dollar earned up to $94,200. The selfemployed pay the full 12.4% while those who are employed share the tax equally (6.2% each) between employer and employee (Internal Revenue Service, n.d.). 3

4 In exchange for paying these taxes, citizens are promised certain guaranteed levels of benefits if they become disabled or elderly. Social Security is a payas-you-go system; this means that taxes are collected on the young and then redistributed to the elderly and disabled. If the taxes are too low or the benefits too generous, then the system will go into financial default. Following World War II, there was a large population boom as soldiers returned home and started families. As this Baby Boomer Generation nears retirement, the demands on the Social Security system will increase. The country will have to decide between the trade-off of maintaining current benefit levels or raising taxes on the young. Question 7: How does Medicare work? Answer 7: Medicare provides long-term health insurance for the elderly. There is a corresponding program for low-income families known as Medicaid. These two programs provide health insurance to a broad segment of society that otherwise could not afford it. Like any government program, taxes must be levied to pay for Medicare. The current tax rate of 2.9% is assessed on every dollar of wage income earned. The self-employed pay the full 2.9% while those who are employed share the tax equally (1.45% each) between employer and employee (Internal Revenue Service, n.d.). Medicare is a pay-as-you-go system; this means that taxes are collected on workers and then redistributed to those who qualify. Under the Bush administration, Medicare has been greatly expanded to include prescription drug benefits. This is but a significant strain on the financial viability of Medicare as a long-term government program. To pay for Medicare, taxes will either have to be raised or benefits will have to be reduced. Question 8: What is a flat tax? Answer 8: The government raises revenues by taxing individuals and firms. The government has control over what activities and goods get taxed and at which rate. Certain activities, goods, or tax payers can be grouped together into a certain class. When the government levies the same percentage of taxation on that class, the government is assessing a flat tax. Another term for flat tax is proportional tax. 4

5 As an example, the government has a flat tax on people who work for wages. The Medicare tax is a flat 2.9% on every dollar earned. A worker who earns her first dollar is taxed at the same rate as a millionaire who earns his or her last dollar. The government collects the same 2.9 from each individual (Internal Revenue Service, n.d.). Economists can debate the fairness or equality of a flat tax. On one hand, a flat tax seems fair because each person pays the same rate no matter how much he or she makes. On the other hand, low-income workers may disproportionately feel the economic pain of the tax. For example, a millionaire might not miss those last 2.9, but a struggling single working mother may need every penny of income. Additionally, Medicare is an insurance program with only a limited amount of benefits available. It may be unfair to ask the very wealthy to contribute substantial sums of money when only a limited number of benefits are available. Question 9: What is a progressive tax? Answer 9: A progressive tax increases as an individual's income increases. In other words, as people's incomes rise, the additional money they will have to pay in taxes will also rise. The federal income tax is a classic example of a progressive tax. The Federal Government classifies income into certain brackets. Each bracket is taxed at a certain rate. The tax rates progress as income increases. Economists can debate the fairness or equity of a progressive tax. On one hand, those who are least able to pay end up paying the least. For those who are most able to pay, they get taxed at the highest rates. However, high marginal tax rates can discourage people from working harder, and it may be unfair to tax people just because they successfully earn higher wages. Question 10: What is a regressive tax? Answer 10: In a regressive tax, the more an individual earns, the less he or she pays in taxes. An example of a regressive tax is the Social Security tax. From $0 to $92,400, the tax rate is 12.4% on every dollar earned in wages. After $92,400, the tax rate falls to 0% (Internal Revenue Service, n.d.). In other words, the tax rate regresses (or falls). Regressive taxes tend to be seen as unfair on the poor working citizens of a 5

6 country. While these workers have the least ability to pay, they are taxed the most. This type of tax also excludes income earned from interest, dividends, capital gains, or royalties. Hence, affluent investors can escape this regressive tax entirely. The available benefits for Social Security, however, are also restricted. It may be unfair to ask workers who make a large amount of money to pay for a limited amount of benefits. Other types of regressive taxes include sales and use taxes. References The Federal Reserve Board. (n.d.). Frequently asked questions: Federal Reserve Banks. Retrieved from The Federal Reserve Board. (n.d.). Open market operations. Retrieved from The Federal Reserve Board. (n.d.). Reserve requirements. Retrieved from The Federal Reserve Board. (n.d.). The discount rate. Retrieved from Internal Revenue Service. (n.d). Self-employed individuals tax center. Retrieved from Self-Employed/Self-Employed-Individuals-Tax-Center 6