If the economy is facing a downturn, there are three general things that the Federal Reserve can do to try to improve the situation.
The Federal Reserve is in charge of monetary policy for the United States. Monetary policy has to do with manipulating the supply of money to either boost the economy or slow it. In this case, the economy is not doing well enough so the Fed (the usual abbreviation for the Federal Reserve) will need to loosen up the supply of money. It will want to increase the supply of money that is available. If more money is available, more consumers and businesses will borrow and spend money. This will increase economic activity and, hopefully, get the economy out of its slump.
There are three things the Fed can do. First, it can lower the required reserve ratio. This would let the banks loan more of the money that they take in. This is not a very effective policy and is not usually used. Second, the Fed can reduce interest rates. This would make the cost of borrowing lower and would encourage borrowing. The Fed often does this in economic downturns. Finally, the Fed can engage in “open market operations.” In this case, it will buy government securities from banks. This will pump money into the banks and encourage lending.
These are the three forms of expansionary monetary policy that the Fed can engage in.
The Federal Reserve can lower the rate at which they loan banks money, known as the prime rate. If they lower this rate, then it will increase consumer and commercial borrowing thus putting more money into the system. If businesses grow, then this will reflect favorably in the stock market and hopefully lead investors to put money into the stock market instead of bonds and bank certificates of deposit; both of these have lower return rates but are generally considered to be safer investments. The Federal Reserve can also target inflation by putting more money into the monetary system.
Still another way the Federal Reserve can help a struggling economy is through quantitative easing, which is the practice of buying financial assets directly from banks. One way to improve the economy that some suggest would be for the Federal Reserve to also buy assets like municipal bonds, which would help cash-strapped governments. Some even suggest that the Fed buy more student loans since this part of the economy is responsible for a great deal of personal debt. These two ideas have not gained traction in Washington, however.