To Set Monetary Policy and Regulate Inflation, We Need the Fed


Though the Federal Reserve is far from perfect (its latest rounds of quantitative easing demonstrate this simple fact), it still provides a vital function for the economy of the United States. The Fed was instituted in order to fill a void — and that void would once again be created if the institution were eliminated.

The Fed was instituted in 1913 after a series of banking panics wreaked havoc on the American economy. By centralizing the reserves of our nation’s banks, standardizing reserve requirements, and creating a lender of last resort, the American banking and financial system finally achieved a state of stability that it hadn’t experienced since the Second Bank of the United States was dissolved in 1836.

The Fed was responsible for creating a standard and uniform currency for the country and also for providing much needed liquidity in the economy and a more elastic currency. The bank panics in the late 19th century occurred and were so damaging because their highly decentralized reserves were unable to be summoned when there was increased customer demand. On the flip side, once additional liquidity was pumped into the system (by JP Morgan or the Treasury as happened during the Panic of 1907), it was very difficult for the money supply to contract once demands had leveled off. This lack of elasticity created the banking panics, but then also exacerbated the problem of increasing inflation once the panics subsided.

The function of providing liquidity and elasticity to our currency is even more important now that we do not have a specie-based currency. When our currency was backed by gold, the value of our currency was self-regulating. When we left the gold standard, however, and adopted fiat money, it quickly became clear that we needed some sort of institution to provide a consistent monetary policy. Fiat money is backed by the guarantee of the government, meaning that it, in and of itself, has no value — a fact worth noting because it means that it does not behave in the same way that gold or silver did, since those were finite commodities which were able to be traded.

The government, in theory, is able to print as much money as it desires without holding the physical assets to back it up; in order to avoid runaway inflation caused by continued increases in the money supply, and also in order to maintain good, market-based interest rates, there needs to be some sort of regulatory institution responsible for setting monetary policy.

If we eliminate the institution responsible for these functions, then we eliminate the gains that were made by the creation of the Fed and we open up our financial and economic system to low consumer confidence, high inflation, or a contracted money supply. The Fed, though it certainly has its problems and has made mistakes, has done a good job of providing a well-regulated and well-balanced monetary policy, something that our economy depends upon.

Photo Credit: rlinger