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How Recessions Work

Monetary Policy

Monetary policy involves manipulating the available money supply in the country. In the United States, monetary policy is conducted by the Federal Reserve System, commonly called the Fed. The Fed is the nation's central banking institution; it is the bank for the government itself, as well as for national commercial banks. The Fed is also in charge of issuing currency, and it is the main regulating body that oversees bank operations.

The Fed mandates that all national banks keep a certain percentage of their assets in one of the Federal Reserve banks, where those assets will earn no interest. This money is known as reserves, and the set percentage is called the reserve ratio.

A bank's assets constantly fluctuate, so they need to quickly adjust their reserves on a regular basis. Banks are not allowed to have too little in reserves, and they don't want to have an excess in reserves (this money isn't earning any interest, after all). In order to keep things balanced, a bank that suddenly has too little reserves can get an immediate, short-term loan from a bank that has an excess. The lending banks charge interest on these loans, at a set rate called the federal funds rate. (Check out How the Fed Works for more information.)

The Fed has several tools at its disposal for manipulating the economy. There are four major things the Fed can do to curb a recession:

  • Reduce the reserve ratio - If banks don't have to keep as high a percentage of their assets in reserves, they have more accessible money. This might lead them to offer more attractive loans to their customers, which can help boost economic growth.
  • Lower the federal funds rate - This frees up more money for banks, allowing them to offer more attractive loans.
  • Lower the discount rate (the rate on federal loans) - This frees up money for banks that are borrowing money from the Fed. Again, these savings may be passed on to the bank's customers.
  • Use its own reserve money to buy government bonds - Buying bonds translates to income for the U.S. government, which puts more money into the economy.

The Fed's power is a double-edged sword. While it can be used to nudge the economy out of recession (or otherwise influence its course), it can also make things a lot worse. The Fed has to be extremely careful in its actions in order to avoid economic catastrophe.

In the end, the course of a nation's recession is controlled by the actions of everybody living in the country. Anything influenced by so many people is beyond the control of any one person or group -- it seems to have a mind of its own. But in the United States, time has proven that attitudes and economic factors shift, and every recession is a temporary recession. Eventually, things turn around and an upward spiral is reestablished.

For lots more information about recessions, the Federal Reserve System and the world of economics, check out the links on the next page.