 Prices out of control. Investors on the run. Twenty dollar bills being ripped to shreds. And a farmer in the American Midwest. They're all connected to one American institution. Hello, I'm Marsha Loeb, editor-in-chief of Fortune magazine. Financial journalists always want to know the answer to one question. The same question asked every day here on Wall Street and on Main Street. What's the Fed going to do next? Will it tighten, which usually leads to higher interest rates, or loosen, meaning interest rates may go down? Well, I'm not here to tell you the Fed's next move because no one outside of the Fed itself really knows. I am here to explain just why the Federal Reserve system plays such a large role in our everyday lives. The easiest way is to look back in time. But not long ago, the biggest concern of most Americans wasn't crime or healthcare or education. It was runaway inflation. If you've forgotten what those days were like, here's a reminder. It's March 1979. Magic Johnson and Larry Bird meet in the finals of the NCAA basketball tournament. The latest fad, pet rocks, which do absolutely nothing. Meanwhile, gas prices are climbing. So are nearly all prices. Everyone's talking about inflation, even the comedians on Saturday Night Live. Inflation is our friend. For example, consider this. In the year 2000, if current trends continue, the average blue-color annual wage in this country will be $568,000. But inflation is no joke. In one way or another, almost everyone is affected. This is NBC Nightly News. Rising prices are considered the country's single biggest problem. Good evening. Prices in the United States during the first three months of 1979 went up at an annual rate of 13%. So while Magic Johnson was winning a national championship, the Fed was worried about rising prices. Al Broadus is president of the Federal Reserve Bank of Richmond. Back in 1979, he was a Fed economist, monitoring the effects of inflation. It discouraged people from saving and investing and building new plants and buying the equipment that we need to grow, investing in technology, doing research and development. It had all of those negative consequences. It was a scary period. October 1979. The Federal Open Market Committee declares war against inflation. The committee includes the seven governors of the Federal Reserve Board and presidents of the Federal Reserve Banks around the country. They regulate the growth of the money supply. And in 1979, they had to do something. Paul Volcker was chairman of the Fed Board of Governors. Inflation can only persist with big growth in the money supply that feeds and supports the inflationary process. So what the Federal Reserve does fundamentally is control the money supply. And we finally reached a point where we said, look, we're just not going to permit and increase the money supply to support this inflation. There is a definite correlation between growth in the money supply and inflation. It's been demonstrated in many countries at many times. Argentina is a case in point. At one time, the government kept printing more and more money, and inflation turned into hyperinflation. Prices were going up by 100% every month. Runaway inflation devastated the national economy. Consumers eventually rioted in the streets. Here at home, the Fed tries to avoid inflation by increasing or decreasing the national money supply. And when it does, the effects are felt throughout the economy. For example, if the money supply is growing rapidly, interest rates tend to go down, at least in the short run. It's a simple matter of supply and demand. When banks have more money available to lend, they don't charge as much interest. In turn, lower interest rates encourage consumers to borrow money. And when people have more money, they're usually willing to spend more for products. Prices tend to go up. That means inflation and all the problems that come with it. Now look at the other side of it. When there's too little money around, the scarcity of money means people will have to pay more to borrow it. Interest rates tend to go up. Because borrowing is more expensive, consumers are less likely to take out loans. In general, people have fewer dollars to buy things with, and businesses cannot raise their prices. Over time, inflation tends to slow down or stop altogether. That's a sheer power of monetary policy. So when prices start going up, the Fed tries to slow the growth of the money supply, which brings us back to our story. It's December, 1980. There's the launching of a new cable channel, MTV. Meanwhile, the U.S. economy is still in trouble. The prime lending rate went to 21.5% today before this week it had never in American history been above 20. Interest rates are rising because the Fed has restricted the growth of the money supply. But no one knows when or if inflation will slow down. The delay, or as we sometimes term it, lag between the time we take an action with monetary policy and the time it has its effect on the economy can be quite long. And we can't predict in advance how long it'll be or exactly how strong the effect will be in a particular instance. One effect in 1980, fewer people can afford to borrow money to buy a new car. The price of the car is bad enough, but the interest rate is ridiculous. High interest rates also create havoc in the housing industry. Throughout the country, people are blaming the Federal Reserve. Thirty years with my wife and three kids, and I've got to worry about what folks are going to do. I'd like the Reserve part to resign themselves. The Fed governors receive hundreds of 2x4s as a symbol of protest and demonstrators gather outside the Federal Reserve building in Washington. I do think there was a feeling in the country then that there was something of an emergency that had to be dealt with. There had to be dealt with by forceful action and a kind of common sense reaction that there would be a little pain in the process. It's October, 1983. Inflation and high interest rates have taken their toll. Companies are borrowing and investing less, and unemployment is rising. But there is one bit of good news. Because people have less money to spend, businesses can't raise prices as quickly. An eventual result? Lower inflation. The inflation numbers for 1983 came out, and they were the lowest that they have been since 1971-72. 3.8%. That's down for more than 12% in 1980. It's July, 1984. The new fashion torn sweatshirts inspired by the movie Flash Dance. Meanwhile, Americans are going back to work, and the unemployment rate is falling fast. At the same time, inflation seems under control. Prices which were going up at more than 13% a year are rising at 4%, which leads to a healthier overall economy. Once we got the inflation rate down, we had the longest expansion in peacetime and recorded American history. We're trying to control inflation and produce a stable monetary system and a stable price level because that will contribute to strong growth and confidence in jobs and income and a high quality of life. That's what we're about, and that's what we're trying to do. There's one significant side effect of monetary policy. The Fed initially raised interest rates, but when Americans grew confident that inflation was under control, interest rates ultimately came way down. The value of savings accounts and investments was no longer being eaten away by prices, so people were willing to save and invest at lower rates than before. It's evident why the Fed's most important job is fighting inflation. Newspapers and magazines sometimes give the impression that it's the Fed's only job, but in fact, there are others, especially involving the country's system of payments, the way we exchange money. The Fed tries to ensure a smooth flow of payments, either made in cash or by check or electronically. Every day, for example, the 12 Federal Reserve banks receive truckloads of currency from local commercial banks which have more cash than they need. The coins are weighed by the bag full and the currency is countered by computerized machines at the rate of 80,000 bills every hour. Bills that maybe counterfeit are rejected and sent to the Secret Service for their investigation. As for currency that's worn out, it's shredded. Every day, nearly $400 million worth of cash is shredded into tiny pieces and then compressed into bricks. Most bills make it through the process. They're wrapped and sent back out to banks that need currency, but most of our day-to-day transactions are made by check and each day, the Federal Reserve system has something like 75 million checks. Then there are electronic transfers of money. Say a company in Boston owes $10 million to another firm in San Francisco. The money can be sent through the Fed's electronic network called Fedwire. The transaction is done by electronic impulses sent across the country. Billions of dollars are transferred daily through a vast network of computers and telephone lines. But the most important element in our overall banking system isn't cash or checks or electronic payments. It's confidence, intangible but indispensable. You're confident your bank will be there when you need to cash a check or use an automatic teller, which wasn't always the case. At one time, the mere rumor that a bank was in trouble could set off a run. You've probably seen the movie, It's a Wonderful Life. A pretty accurate depiction of what a run looked like. Don't look now, but there's something funny going on over there at the bank, George. I've never really seen one, but that's got all the earmarks of being a run. Hey, Eddie, you got any money in the bank at Federal, hurry! Bank failures are still something everyone wants to prevent, even though these days, small depositors are insured by the federal government. One way to prevent failures is to examine banks on a regular basis. Now, in the movies, a visit from the bank examiner is about as welcome as a root canal. Good morning, sir. Carter, bank examiner. Mr. Carter, Merry Christmas. Merry Christmas. We're all excited around here. My brother just got the Congressional Medal of Honor, a present just decorated. Yeah, well, I guess they do those things. I trust you had a good year. Good year? Well, between you and me, Mr. Carter, we're broke. Yeah, very funny. In real life, things don't work quite that way. Bank examinations are conducted by various government agencies, including the Fed, and the examiners have little in common with Mr. Carter. The team has arrived. Five bank examiners from the Fed. Their home base is the Federal Reserve Bank of St. Louis, which is responsible for examining state-chartered member banks in its district. On this day, they're in Jacksonville, Illinois. All right, a beautiful day here in Jacksonville in our great state of Illinois. We have 58 degrees. The relative humidity stands at 80%. 19 minutes past eight. It's 8.19, and the team is checking the books. The company made pretty good profits for this year. $100,000 in income. Unlike the movies, this visit is scheduled in advance, and it's done in a spirit of cooperation. The bank being examined is Elliott State Bank. It's been in business in the same location for more than 125 years. The bank has lent money to the local radio station, to a small college in Jacksonville, and to farmer Donny Headon. I needed a combine, and it was going to take $20,000 at that particular time. I wasn't liquid, so I went to the bank, to Elliott Bank, and they loaned me the money. Of course, all the loans have to be paid back. Because if enough loans aren't paid back, Elliott State Bank could go out of business. So the examiners try to make sure that the loans are safe. It's helpful to have an outside party come in and look at the books. We can help them spot difficulties before they arise and maybe give some advice and some information that may prevent a problem from arising. And that's helpful, I think. I think many bankers see it that way. It's clear that the Fed has a major influence on the banking system and the overall economy on things like jobs and prices and interest rates. Over time, the Fed's methods have changed to take advantage of the latest technology, but its mission remains the same as it was back in 1913 when the Fed was created to aim for stable prices, for a sound banking system, and for a growing economy. Now, if I only knew what they were going to do next, I'm Marshall Loeb, and thanks for watching.