Basic Explanation of what the Federal Reserve does

Okay, I’m gonna try. Here’s what I know without trying to overreach what I know. My sources for this are a class on political economy I took in college, then gave up on because it was too tough.

So the Federal Reserve is like a public financial face of the United States Government and it’s people. Let’s say you live in California and you sell oranges. A guy from Japan comes and he wants to buy your oranges but he has yen. You take then yen, with the knowledge that you got a good price for them comparatively speaking. He takes the oranges, everyone’s happy. You then take these yen notes and bring them to your local bank which in all likelyhood is a mega bank like TD Bank or Wells Fargo or whatever. They take your yen and give you dollars. Then Wells Fargo brings your yen and all of the other yen people have given it and brings it to the Federal Reserve. The Federal Reserve gives them the equivalent in US dollars and now the fed has the money. Now the Fed gathers all of its yen that the banks have given it and they meet with Japan. Japan has US dollars that it doesn’t know what to do with either. If Japan has as much USD as the Fed has Yen, (adjusted to the foreign exchange rate of course, like 1000 yen is like 1 USD or something) everyone walks away happy. If the Federal Reserve still has yen left over, that means that the Japan owes the United States. That’s called a trade deficit. Japan now has a trade deficit to the US, and that’s when you buy products from foreign countries more than other countries buy from you. I believe this is a way that a country can get into debt, that it imports too much and exports too little.

Now I’m going to move into territory I know less about. Remember the foreign exchange rate? Simple concept, right? I don’t need to explain it, right? The Federal Reserve can actually raise or lower the value of their currency relative to the other global currencies by printing more of it or restricting its printing. So let’s say it’s 5 Pesos to 1 USD. (The numbers are horrifically off, I know, roll with me.) If they print lots of money in one year, the exchange rate will go to 10 Pesos to 1 USD. Now why would somebody want to do that? Because let’s say you live in a Mexican town not far from the US border. When the exchange rate is 10 pesos to 1 USD you can buy more in America with the same amount of money than you could in Mexico. So it attracts people to buy a lot more stuff in your country. And remember what I said before about having a trade deficit? If your country has been buying a lot of stuff from other countries but other countries haven’t been buying your stuff, you now have a trade deficit. But you can lift the trade deficit and get people to buy your stuff by devaluing your currency.

But what happens when you limit the amount of USD? Then your dollars get more stuff from people overseas. If the exchange rate before was 1 USD = 10 Pesos and now it’s 1 USD = 4 Pesos that means that you as an American can buy more things from Mexico than you could when the exchange rate was 1 USD = 10 Pesos. Your dollars are more potent. Someone would want a strong dollar when they’re buying things from overseas.

And finally, you can increase or decrease the dollar supply by making loans to banks. You round up all of the big banks, and you give them loans that they have to pay back with interest. Now this has to do with Quantitative Easing and controlling Interest Rates and I don’t know enough to speak confidently on the subject so that’s where I’ll leave you.

But it’s enough to say that the Federal Reserve plays a massive, massive role in the United States economy and because the US is also the leading economy in the world, also the global economy as well. You should think of the Federal Reserve as a conductor of an orchestra making music, and the proletarians are the violins being played. Even David Harvey says that no one really knows what goes on inside the Federal Reserve.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s