What Federal Reserve, Banking, and Inflation Are

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The Federal Reserve System was created in 1931 because there were bank failures during those periods. Economies in the world rely on supply of currency within their country and it is this reason why the Federal Reserve System was created for regulating the supply of money. It was also started as a central financial institution regulating the quantity of money to ensure the success of banks.

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The functions of Federal Reserve System are to regulate the amount of money being supplied in the economy also to ensure that interest rates are controlled. The Federal Reserve System are the sole bank that distributes new currencies in the country. They also act as bankers for the government. They also oversee the functioning of commercial banks.

The Federal Reserve System is governed by governors who are appointed by the president and confirmed by the senate. They normally have a term of 14 years. The board of governors of the Federal Reserve has the chairman, who chairs the meeting for the reserve bank meetings. The bank has also board of directors.

The Federal Reserve System controls the supply of money in the economy by employing three tools, Open Market Operations, reserve requirements and discount rates.

Open market operations consist of selling or buying of government securities by the bank on the stock exchange. If the bank sells securities, buyers pay by means of cheque drawn on the commercial banks. The balances on the commercial bank will therefore, be reduced and if the reserve assets ratio is to be maintained, then bank advances must be reduced. Funding is an aspect of open market operations. It means lengthening the age structure of the national debt by issuing less short-term debt and more long-term or funded debt. In this way the central bank can alter the banks opportunities to purchase liquid assets, because treasury bills are easily converted into cash. Thus, if the bank wishes to decrease the money supply, the sale of treasury bills is restricted by converting the desired amount of short-term debt into funded debt. Consequently the banks must seek alternative liquid assets to reduce deposits.

Bank rates as an instrument of credit control: The bank rate is used to influence rate of interest and hence, the cost of borrowing. Technically, bank rate is the minimum rate at which the central bank is prepared to re-discount bills of exchange brought to it by members of money market. However, the chief importance of bank rate rests in its function as the sheet of anchor of interest rates throughout the country. Changes in the bank rate influence other rates of interest. When bank rate is raised, borrowing becomes more expensive and demand for loans is reduced, thereby reducing purchasing power. Conversely, a reduction in the bank rate will lead to expansion of bank deposits. The resulting fall in overdraft rates will encourage borrowing, while saving will be discouraged because of the lower rate of interest paid on savings.

Minimum lending rate:- The role of bank had been severely modified by the governments new policy on competition and credit control introduced in 1971, and since then bank rate had been less an instrument of public policy and more a technical lending rate of last resort in the money market. For the successful work of bank rate, a number of conditions have to be satisfied:

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  1. Efficacy of bank rate in controlling credit requires a closer relationship between the bank rates and other interest rates in the money market.
  2. No excess reserves. The necessity for commercial banks to approach the central bank for rediscounting is an important factor in determining the successful working of the bank rate. But commercial banks will have no need to approach the central bank when they have ample liquid resources at their disposal.
  3. The successful operation of the bank rate policy presupposes an elastic economic structure so that changes in credit conditions should lead to corresponding changes in wages, rents, production, trade, etc.


Banks increase the money in supply by giving out loans to members of the public and this creates. If the interest rates are favourable for members of the public they go to banks to borrow and this causes the amount of money in the economy to go up.


Inflation is measured by the price levels in the economy. If changes in price levels are high then it means there is a high rate of inflation taking place in the country.

Inflation represents a situation whereby the pressure of aggregate demand for goods and services exceeds the available supply of output. In such a situation, the rise in price-level is the natural consequence. Now this excess of aggregate demand over supply may be the result of more than one force at work.

Cost push inflation:-If inflation is mainly induced by rising costs of production, it can be described as a cost-push inflation. one can visualize a situation where, even though there is no increase in aggregate demand, prices may still rise. This may happen if costs, particularly the wage-costs, go on rising. Now as the level of employment rises, the demand for workers also rises so that the bargaining position of the workers becomes stronger. To exploit this situation, trade unions ask for an increase in wages rates which are not related to increases in productivity or the rise in the cost of living. The employers in a situation are likely to concede to higher wages claims. As labour costs are often one of the main costs of production, firms may be compelled to raise the prices of their goods and services, in order to cover the addition to the wage bill. However the price prizes will lead to a further round of wage demand as people Endeavour to restore the buying power of their incomes. In turn, further price increases will result and the chain of events will continue to repeat itself in an inflationary spiral of prices and incomes.

  1. Increase in money supply unaccompanied by proportionate increase in the output of goods and services.
  2. Increase in the community’s aggregate spending which naturally leads to greater demand for the economy’s output and raises its price.
  3. If for any reason, such as famine and drought, abnormal industrial unrest, the volume of production falls.
  4. Excessive and undue speculation and tendency to hoarding and profiteering on the part of producers and traders.
  5. Rise in wages rates and other costs.

Natural disasters do not cause inflation but causes deflation. This is because natural disasters cause a temporary price change in a specific area but not in the whole country. Inflation affects the whole country. The public will only observe the price changes in an area.

Inflation has many costs which affects the economy. To begin with inflation causes the following problems.

  1. There is a fall in the purchasing power by increasing the value of goods. This increase in prices will affect wages, or goods capital and technology. If income does not increase at the same rate inflation is taking place, then purchasing power of the people will go down.
  2. The changes in prices of goods and services affects consumption as well as companies tend to change prices now and then to suit the price of inflation. Inflation also cause tax distortion as it is not easy to measure the amount of tax to be collected by the government. This will hamper development.
  3. There is misallocation of resources because during inflation some of amounts designated for capital development may directed towards consumable goods thus hampering development.
  4. There is confusion and inconvenience among citizens of a country because of inflation.

Lastly inflation is the most feared issue in the world today inflation causes stagnation in economic development, reduces consumption, price skyrockets, creates unemployment, and there may be strikes and demonstration because of high food prices. Inflation may be the cause of high food prices in the world.

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Mankiw, N. Gregory (2006);Principles of Economics; Thompson South-Western; 4th edition.

Mankiw, N. Gregory (2007);economics : Principles and applications.

Robinson, J. and Eatwell, J. (1973), An introduction to Modern Economics, McGeaw Hill Book Company (UK) Limired.

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