What Exactly Is the Federal Reserve and Why Does It Matter to My Money?

What the Federal Reserve Is#

The Federal Reserve is the central bank of the United States. It was formed by Congress in 1913 to help make the national economy and financial system safer and more stable.

What the Federal Reserve Does#

The Federal Reserve influences the money supply and credit conditions in order to accomplish several goals: to promote steady prices and full employment, to promote stability in the financial system, and to facilitate sustainable economic growth. Other duties include regulation of the banking industry and making sure consumers have access to the information they need in order to participate in the financial system.

Although the Fed is the central bank of the United States, it is not really a true government institution. The Fed is not funded by tax dollars, and its decisions do not have to be approved by the President or either house of Congress. The Federal Reserve is subject to Congressional Oversight and any changes in the law that Congress passes. To ensure fair representation on the Board of Governors, there may not be more than one governor from each of the twelve Federal Reserve Districts across the nation.

Who Sits on the Board of Governors#

The Federal Reserve Board of Governors is a seven-member committee. Members are chosen by the President, confirmed by the Senate, and serve fourteen-year terms.

What the Federal Open Market Committee Is#

The Federal Open Market Committee is made up of the seven members of the Federal Reserve Board of Governors and five Reserve Bank Presidents. The President of the Federal Reserve Bank of New York is always a member of this committee.

What the Discount Rate Means#

The discount rate is the rate the Federal Reserve charges banks that borrow directly from it. These are very short-term loans, usually overnight, meant to cover shortfalls in reserve requirements.

What Is Gross Domestic Product?#

GDP is short for Gross Domestic Product, which is the total dollar value of all final goods and services produced in a country in a given year. It is calculated as Consumption + Investments + Government Spending + Net Exports.

• Consumption: the dollar value of goods and services purchased by consumers, such as food, clothing, and landscaping services.
• Investments: money put directly into a business, for example when a company builds a new factory or buys new equipment. Stock market and other securities transactions are not included in GDP at all.
• Government Spending: the dollar amount of goods and services purchased by the government.
• Net Exports: the total dollar value of goods exported minus the total value of goods imported.

Second-hand items, such as used cars, are not included, because they were counted as part of GDP when they were originally sold. Since GDP is based on prices, economists often use a statistic called Real GDP, which is GDP adjusted for the effects of changes in prices, to capture true output rather than price changes.

What Does Gross Domestic Product Mean to Me?#

GDP will not have a direct impact on most people’s lives, but it does impact government policy on topics as diverse as tax policy and the level of funding for social programs. Since GDP measures output, it is a good measure of the overall health of the economy.

Why Do Recessions Occur?#

A recession is defined as two consecutive quarters of negative Gross Domestic Product (GDP) growth, meaning the output of the economy shrinks. Recessions can occur for many reasons, including a slowdown in consumer spending, high interest rates, high debt levels, and a general lack of confidence in the economy’s prospects, though the root cause is still the subject of considerable debate. Most recessions are characterized by large numbers of layoffs, difficulty in finding jobs, and reductions in income, and it is common for both business and personal bankruptcy filings to increase during recessions.

If the economy experiences a recession, the most common solution is to stimulate growth by reducing interest rates and increasing government spending, but this strategy does not always work. The most important step anyone can take is to build a solid financial plan that includes creating and using a budget, savings, and debt reduction.

What to Do Next#

Understanding how the Federal Reserve works can help you make sense of the financial news that affects your bank and your money. Cambridge Credit Counseling offers free resources to help you understand your own finances better, including a downloadable financial wellness guide called Learn Now or Pay Later that covers budgeting and other financial topics.

For more information on the Federal Reserve, visit the Federal Reserve’s website.