If you have picked up a financial paper or read the business section lately, you have probably read about the FED, Discount Rates, Overnight Rates, and Open Market Operations. So what are these things and how do the activities of the Fed affect you?

Formally known as the Federal Reserve, the Fed is the gatekeeper of the U.S. economy. The Fed regulates financial institutions, manages the nation's money and influences the economy. By raising and lowering interest rates, creating money and using -other methods, the Fed can either stimulate or slow down the economy.

The Fed uses three tools:

• The reserve requirement
  
• The discount rate
  
• Open market operations

The reserve requirement is the balance that banks must maintain to ensure they have available money for their customers. It is typically a percentage of their total interest-bearing and non-interest-bearing checking account deposits (currently 3-10%. Changing this requirement has a large effect on the economy and is rarely used. The last time the rate was changed was in the early 1980’s.

In the event that a bank's money supply drops below the required reserve amount, that bank can borrow either from another bank or from a Reserve Bank. If it borrows from another bank's excess reserves, then the loan takes place in a private financial market called the federal funds market. The federal funds market interest rate, called the funds rate, adjusts accordingly to the supply and demand for reserves.

If a bank chooses to borrow emergency reserve funds from a Reserve Bank, then it pays an interest rate called the “discount rate.” This was lowered by one-half percent in late August in reaction to the credit crunch.

The discount rate is the interest rate that a regional Reserve Bank charges banks and financial institutions when they borrow funds on a short-term basis.

The discount rate often plays a larger role in the overall monetary policy than would be expected because it is a visible announcement of change in the Fed's monetary policy. This is the most talked about rate and can affect your mortgage and credit card rates.

The Fed more often alters the supply of reserves available by buying and selling securities. All of this buying and selling is referred to as “open market operations.”

The most effective tool the Fed has, and the one it uses most often, is the buying and selling of government securities in open market operations. Government securities include treasury bonds, notes, and bills. The Fed buys securities when it wants to increase the flow of money and credit, and sells securities when it wants to reduce the flow.

Sometimes, in order to understand why you need something, it helps to find out what it was like before that "something" was created. Before the Federal Reserve was created in 1913, there were over 30,000 different currencies floating around in the United States. Currency could be issued by almost anyone -- even drug stores issued their own notes. There were many problems that stemmed from this, including the fact that some currencies were worth more than others.

There were even times when banks didn't have enough money to honor withdrawals by customers. Imagine going to the bank to withdraw money from your savings account and being told you couldn't because they didn't have your money!

Before the Fed was created, banks were collapsing and the economy swung wildly from one extreme to the next. The faith Americans had in the banking system was not very strong. This is why the Fed was created.

The Fed's original job was to organize, standardize and stabilize the monetary system in the United States. It had to set up a method that could create "liquidity" in the money supply -- in other words, make sure banks could honor withdrawals for customers.

Source: HowStuffWorks, Lee Ann Obringer