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Thursday, May 11, 2006

The Federal Reserve System

Nick Blanchette
Professor Francis T. Talty
Introduction to American Politics
04/21/06

The Federal Reserve System

The Federal Reserve System, often referred to informally as the Fed, is the central banking system of the United States of America. The Federal Reserve System was created by Congress and signed by President Woodrow Wilson on December 23, 1913 when they passed the Federal Reserve Act written in chapter 3 of title 12 within the United States Code (Board of Governors of the Federal Reserve System 1). The United States Constitution gives Congress the power to regulate commerce between states but in the Federal Reserve Act, Congress gave the power to make monetary policy to the Federal Reserve System (Wilson 501). The Federal Reserve System is run by the Federal Reserve Board which consists of seven members who are appointed by the president of the United States and approved by the Senate (Wilson 500). Each member is limited to one term which lasts for fourteen years unless removed for cause by the president (Wilson 500).

The Federal Reserve System includes twelve central Federal Reserve Banks (Board of Governors of the Federal Reserve System 48). The Federal Reserve Bank prints all the nations’ money and is the only bank with the authority to do so. The twelve Federal Reserve Banks are essentially a bank for banks and for the federal government. Banks and other financial institutions hold accounts in the Fed for the same purpose one would hold a personal account in a regular bank. The banks and other financial institutions can write checks, electronically transfer funds, and save money in an account at the Fed. The National Government under the United States Department of Treasury holds their accounts in the Federal Reserve Bank (Financial Services 1). The Fed provides the Treasury with all their financial needs which include redeeming government securities, lending money, and holding their accounts. However, the Federal Reserve is much more then just a bank.

The Federal Reserve System is run like any other corporation in America, with a Board of Governors named The Federal Reserve Board. There are four aspects to the basic structure of the Federal Reserve System. First is the Federal Reserve Board, which makes the decisions and directs the actions of the Federal Reserve System. Second is the Federal Open Market Committee (FOMC), which includes the members of the Federal Reserve Board. The FOMC makes all decisions and policies as they relate to open market operations in the financial system in America. Third, in the basic structure of the Federal Reserve System are the twelve Federal Reserve Banks. The twelve Federal Reserve Banks have their own autonomous board of directors which consists of five to seven members. These boards are responsible for the supervision of the day to day operations of the Reserve Bank and making recommendations on monetary policy. Fourth, in the basic structure of the Federal Reserve System are the member or primary banks that do business with the Fed (Federal Reserve 1).

The Federal Reserve System, run by the Federal Reserve Board, “was intended to be little more than the coordinator of the activities of the Federal Reserve banks created by the Federal Reserve Act” (Whitnalt 239). The Role of the Federal Reserve Board has expanded over time to include many other areas: conducting the nation’s monetary policy, supervising and regulating banking institutions, maintaining the stability of the United States financial system, and providing financial services to depository institutions. The Federal Reserve is also involved in economic research, economic education, and community outreach.

“The term ‘monetary policy’ refers to what the Federal Reserve, the nation’s central bank, does to influence the amount of money and credit in the U.S. economy. What happens to money and credit affects interest rates (the cost of credit) and the performance of the U.S. economy” (Federal Reserve 1). The goal of the Federal Reserve’s monetary policy is to maintain price stability, manage inflation, and sustain economic growth achieving full employment (Beckhart 1). The way the Federal Reserve implements its monetary policy is through open market operations, setting the discount interest rate, and setting the reserve ratio.

Open market operations are the way the Federal Reserve Board maintains the money supply within the economy (Federal Reserve 1). All decisions of open market operations are decided by the Federal Open Market Committee which consists of twelve members; the seven members of the Federal Reserve Board and five of the twelve Federal Reserve Bank presidents (Federal Open Market Committee 1). The presidents serve a one year term rotating between the twelve Federal Reserve Banks but the New York Federal Reserve President always sits on the board because all open market operations are done at this branch (Federal Open Market Committee 1). The reason it is called open market operations is because the Federal Reserve Bank does this business with twenty two member banks called primary dealers. All the primary dealers hold accounts in the Federal Reserve Bank.

Through open market operations the Federal Reserve Board either temporarily or permanently increases or decreases the money supply within the economy. The way the Fed temporarily alters the money supply is through either buying or selling previously issued U.S. Government securities for a designated amount of time. To increase the money within the economy, the Federal Reserve in New York will buy securities from a primary bank and deposit the funds for the purchase in the account of that bank held at the Federal Bank for a designated amount of time. This will increase the money reserves for that bank until they have to settle the account with the Fed and buy back the securities it earlier sold them. Temporarily having more reserves in their account at the Fed will allow them to lend out more money to the American people, thus increasing the money supply within the economy. To decrease the money supply within the economy, the Federal Reserve Bank of New York will sell securities to a member bank. For payment, the Fed withdraws the funds from the account of that bank held at the Fed effectively decreasing the reserves of that bank, which in turn limits the loans that bank can give.

These transactions are called repurchase agreements (repos) when the Fed temporarily increases the money supply in the economy; and they are called reverse repos when they decrease the money in the economy. The term of the repo can last as long as sixty five days and as little as one day but typically they are either over night or fourteen day repos. The way the Fed permanently alters the money supply is through outright transactions. There are very similar to repos in every way except for these transactions are permanent not settled after a designated amount of time. The Federal Open Market Committee through open market operations tries to maintain a stable economy that neither rises nor decreases too rapidly or slowly.

“There is nothing that the fed can do to guarantee that our economy will grow at a healthy pace or that it will provide a job for everyone who wants one. However, the fed can create an environment that is conducive to economic growth. The fed does this by pursuing a goal of price stability – that is, by maintaining inflation at a rate that does not affect business or household spending decisions” (Federal Reserve Education 1).

The Federal Reserve directly sets the discount rate, which is the rate the primary dealers pay to borrow money from the Federal Reserve Bank (Wilson 500). The Fed can lower the interest rate to boost the economy or raise the rate to stabilize it. The Fed, in most circumstances, does not increase or decrease the discount rate by more than a quarter of one percent or half of one percent in order to keep the economy from extreme movements. Although the Fed does not have direct influence on the interest rates other banks charge, they can influence the rates of other banks through open market operations. The Open Market Committee through open market operations of buying and selling money affects the interest rates. When the Federal bank buys U.S. Government securities and credits the primary dealers account at the fed, the primary dealer has higher reserves which allow it to lend out more money (Board of Governors of the Federal Reserve System 11). This creates downward pressure on the federal funds rate, which is the interest rate the primary dealers charge other banks they do business with, which in turn will free up banks to set lower interest rates on loans and other rates in the economy. The opposite is true when the Federal Bank sells U.S. Government securities and withdraws the funds from the primary dealers’ account. This lowers the amount of money they can loan to the other banks they do business with, effectively decreasing the money in the economy which increases interest rates.

The Federal Reserve Board in its attempt to regulate monetary policy manages the laws regarding the reserve ratio. The reserve ratio, which is conceptually related to fractional-reserve banking, is the amount of money that banks have to keep available in order to satisfy demands for withdraws (Reserve Requirement 1). Banks are only required to keep a fraction of what they receive for deposit in order to loan out the rest for interest. The theory behind fractional-reserve banking is as follows: not everybody is going to try to withdraw their money at once, therefore, there is no reason to hold all the money (Federal Reserve 1). In order to make a profit, the banks will loan out the money they receive on deposit for interest, and then pay the depositor a lot less interest for the money deposited. The Federal Reserve Board regulates what percentage the banks have to keep on deposit with a minimum required reserve ratio. According to wikipedia.org, currently in the United States the minimum required reserve ratio is ten percent (Reserve Requirement 1). Though they rarely change quickly, over time the Federal Reserve Bank can increase the money supply in the economy by lowering the percentage required to be held for fractional-reserve banking. Likewise the Fed can decrease the money supply in the economy by increasing the percentage required to be held for fractional-reserve banking, thus reducing the amount banks can loan out.

The Federal Reserve Board in the Federal Reserve Act was given the power not only to make monetary policy but also to regulate and supervise banking institutions. The Federal Reserve Board has the power to make the laws the banking institutions have to follow as well as take charge of enforcing these laws. The twelve Reserve Banks follow these laws and supervise all primary banks, all financial institutions, and international institutions that do business with the United States. The Fed is in charge of

“establishing safe and sound banking practices; protecting consumers in financial transactions; and ensuring the stability of U.S. financial markets by acting as lender of last resort. The common goal of all three duties, however, is the same: to minimize risk in the banking system” (Federal Reserve Education 1).

The Federal Bank is also the insurance agency of the smaller banks in order to protect the American people. If a bank is in trouble financially and in need of a loan, the Federal Bank will loan that bank money so that it will not disrupt the entire banking system. The Federal Banking Board is given these powers in order to maintain a stable federal banking system in the United States.

The Federal Reserve System is the central banking system of the United States of America and has a vital part in keeping the financial aspect of our society running and growing. The significance of the Fed is that it is responsible for maintaining the nation’s economic growth through the powers granted it in the Federal Reserve Act. The Fed is directed by the Federal Reserve Board, which is full of highly educated individuals who walk a tight rope balancing all the intricate details that can swing an economy in one direction or another, trying to maintain economic growth. In order to accomplish this, the Federal Reserve Board has the power to conduct the nation’s monetary policy, supervise and regulate banking institutions, maintain the stability of the United States financial institutions, and provide financial services to depository institutions. The Federal Reserve implements its monetary policy through the Federal Open Market Committee which makes all decisions regarding open market operations, sets the discount interest rate, and sets the reserve ratio. Finally, the Federal Reserve Board through the Federal Reserve Act was given the power to regulate and supervise banking institutions through making the laws the banking institutions have to follow as well as enforcing these laws.

Works Cited

1. Beckhart, Benjamin Haggott. Federal Reserve System. New York:
American Institute of Banking, 1972
2. Board of Governors of the Federal Reserve System. 29 March 2006. <http://www.federalreserve.gov/>
3.Board of Governors of the Federal Reserve System. The Federal Reserve System: its purposes and functions. Washington:
National Publishing Company, 1947
4.Federal Open Market Committee. <http://en.wikipedia.org/wiki/Federal_Open_Market_Committee>
5.Federal Reserve. 28 March 2006. <http://en.wikipedia.org/wiki/Federal_Reserve>
6.Federal Reserve Education. <http://www.federalreserveeducation.org/FRED/>
7.Financial Services. <www.federalreserveeducation.org/fed101/services/>
8.Reserve Requirement. <http://en.wikipedia.org/wiki/Reserve_ratio>
9.Whitnalt, Donald R., ed. Government Agencies. Connecticut:
Greenwood, 1983
10.Wicker, Elmus R. Federal Reserve monetary policy. New York:
Random House, 1966
11.Wilson, James Q., and John J. Dilulio. American Government. Boston:
Houghton Mifflin Company, 2006

1 Comments:

Anonymous Basil Pereira said...

Very interesting article. I wonder however if too much power is held by the Federal Reserve Bank, so much so that it not only controls the money supply of the US, but can even dictate the foreign policy and defence policy of the US since neither the President nor Congress has the authority to issue debt-free currency. The power of the president is hence nil, and in the case of war, he has practically to beseech the Federal Reserve Bank to support him. This system may have started as a noble ideal, but in the long run, it can be manipulated by greedy international bankers and even cause a Depression, as happened in the 1930s. I hope it doesn't happen of course.

8:10 AM  

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