Business Finance

Basic Guide to the Federal Reserve

Written by Clayton Reeves for Gaebler Ventures

We explain the purpose and duties of the Federal Reserve. While it might not seem like they have an impact on your business, they certainly do.

Although your small business may never deal directly with the Federal Reserve Bank, it is the single most important financial institution in the United States and, arguably, the world.

The Fed is responsible for the money supply, educating the markets, stabilizing the economy, the security of our banks, regulating interest rates, and the creditworthiness of our government.

They have four primary responsibilities.

Supervising and regulating commercial banks

The Fed manages commercial banks along with several other agencies. They have regulatory responsibility over commercial banks and set the overnight lending rate. The Federal Reserve also regulates bank holding companies and supervises state chartered banks.

Serving the banking industry

This is a broad definition of the many functions that the Fed serves for the banking industry. Their role is a "banker's bank." This means they perform many of the functions a bank normally serves for customers for other banks. Responsibilities include transferring money and checks, replacing bills, wire services and providing loan services to nationally chartered banks. Commercial banks also generally hold a balance with the reserve like any customer usually would.

Being the US government's bank

This is one of the more important functions of the Fed. The national government needs a bank to perform services such as checking accounts and money transfers. Also, loans and things of that nature are needed by some government agencies from time to time. The New York branch of the Federal Reserve performs these functions for the US government.

Monetary policy

This is the single most important function of the Federal Reserve, and it is also the one that impacts your business the most. Monetary policy involves the supply of money and how that affects the overall economy.

There is a finite amount of money in the marketplace. This supply of money is controlled by the Federal Reserve. As is usually the case, on the opposite side of this supply is demand for money. Demand for money usually increases in expansionary periods where businesses need money to take advantage of good investment opportunities. This increase in demand increases the price to borrow, or the interest rate. The interest rate, at the most basic level, is simply how much a company is willing to pay to borrow a sum of money for a certain period.

As the price to borrow goes up, the companies with the best opportunities will be willing to pay the most to borrow. This creates equilibrium in the market. When the supply of money goes down, the price to borrow goes up. Scarcity of a product or item usually increases the price, and this is the same for money. The Fed has several options to increase and decrease the supply of money.

The most common is open market operations. In these instances, the Fed actually sells or buys treasury securities to either lower or raise the amount of money in the market.

It is important, as a small business owner, to know what part of the cycle the money supply is currently in. Right now, with credit being relatively tight, it seems like there isn't a lot of money out there. However, since interest rates are so low, there should be a good supply of money. The problem is the insecurity of the markets and people's unwillingness to part with their money without a large risk premium.

Knowing how the money supply is controlled can help you better understand the movements in the market.

When he's not playing racquetball or studying for a class, Clayton Reeves enjoys writing articles about entrepreneurship. He is currently an MBA student at the University of Missouri with a concentration in Economics and Finance.

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