The Federal Reserve

Do you notice when gasoline prices go up and up and up? When that happens, who will stop them from going to astronomical levels? What's the force that drives housing prices? Which institution intervenes whenever the economy goes into recession?

All these questions can be addressed once you learn about the Federal Reserve System, and this article will teach you everything you need to know about it.

The Federal Reserve Definition

Often referred to as "the Fed," the Federal Reserve System (FRS) is the central bank of the United States and perhaps the most powerful financial organization globally. It was established to give the nation a monetary and financial system that was secure, adaptable, and stable.

Fig. 1 - Flag of the United States Federal Reserve Bank

To understand what the Federal Reserve System does you would have to understand the role of a central bank in an economy. First, it is not like other types of banks that serve consumers and businesses. Instead, the central bank serves as the banking institution for these other types of banks.

A central bank serves as the financial institution with exclusive power over the circulation of money in a country or set of countries. It is responsible for ensuring that the money flowing within the economy is stable. Additionally, it regulates other financial institutions in order to bring stability or help maintain stability in the financial environment.

Before the Federal Reserves System was created, the United States was the only major financial power that did not have a central bank. Throughout the 19th century and the beginning of the 20th century, the United States economy was plagued by recurrent financial panics. This resulted in significant economic disruptions due to a large number of banks and businesses failing in a very short period of time and spurred the U.S. government to create a central bank in 1913.

The Federal Reserve System has extensive authority to intervene in the financial system to maintain stability, and it is the central regulator of banks that are members of the system. It serves as a lender of last resort for member institutions that have exhausted all other options for borrowing money from other sources.

System of the Federal Reserve

The Federal Reserve System is comprised of twelve regional Federal Reserve Banks, each of which is responsible for a particular geographic region of the United States. Each of them has a president, and they supervise the region to which they belong. They are located in Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, San Francisco, San Jose, and the headquarters in Boston.

Additionally, the Federal Reserve System consists of the Board of Governors whose function is to supervise and regulate the twelve Federal Reserve Banks. The Board of Governors is located in Washington D.C. It has seven members, each appointed by the President and approved by the Senate. They serve for a term of fourteen years to remove any exposure to the ruling party's politics.

In terms of its legal structure, the Federal Reserve is not part of the U.S. government, nor is it owned by private institutions; instead, it governed by the Board of Governors that oversee the twelve Federal Reserve Banks.

The Federal Reserve Act

After a particularly bad panic of 1907 that caused a run on the banks and significant losses to business and personal wealth, Congress enacted the Federal Reserve Act. This act established the central bank and the Federal Reserve System. It was signed into law by President Woodrow Wilson on December 23, 1913.

The Federal Reserve Act established the twelve regional Federal Reserve Banks as the system that is responsible for managing the country's money supply, overseeing banks, and acting as a lender of last resort. Additionally, the Federal Reserve Board of Governors, whose members are selected by the president, was formed to provide leadership for the Federal Reserve System.

After another series of bank runs between 1930 and 1933, several additional laws regarding the banking system were enacted in 1933. The 1933 Banking Act was an amendment to the Federal Reserve Act. It established the Federal Reserve's Open-Market Committee, responsible for overseeing the Federal Reserve's activities in the financial markets.

Functions of the Federal Reserve

Functions of the Federal Reserve include: creating monetary policy, providing financial services, regulating and supervising the banking system, maintain a stable financial system.

Monetary policy

Perhaps this is one of the most critical functions of the Federal Reserve. The Fed uses different tools in the monetary policy process to address macroeconomic issues. When there are major macroeconomic shocks in the economy that affect the GDP of the United States or cause inflation, the Fed is in charge of managing these problems.

Providing financial services

Another main function of the Fed is to provide financial services to other financial institutions and the U.S. government. Commercial banks and other types of major financial institutions use the Federal Reserve Banks to store their money, process checks, receive cash, as well as transfer funds.

Additionally, the United States government uses the Federal Reserve for financial services. The United States Treasury maintains a checking account with the Federal Reserve, which means that when the federal government issues a check, the check is made on a Fed account.

Regulate and supervise banking institutions

Regulating and supervising banking institutions is another essential function of the Federal Reserve System. The Fed makes sure that commercial banks adhere to existing financial rules and regulations. This is important to reduce the risks faced by commercial banks. When commercial banks engage in too much risk, the Federal Reserve steps in. The Fed is responsible for overseeing commercial banks.

Maintain a stable financial system

A sound and stable financial system enable the economy to prevent recessions such as the 2008 financial crisis. The Federal Reserve’s function is to ensure that all the financial institutions in the economy and the financial system as a whole are efficient and stable. When financial institutions are at risk of collapsing, the Fed helps them out by providing liquidity and mitigating the spillover effects a financial institution’s bankruptcy would have on the economy.

Monetary Policy tools used by the Federal Reserve

There are three main tools that the Fed uses to ensure a stable economy and stable prices. Those three tools include: reserve requirements, the discount rate, and open-market operations.

Reserve requirement

The reserve requirement is a ratio set by the Federal Reserve, which requires commercial banks to keep a specific portion of their checkable deposits in their reserves. If the reserve requirement ratio was 10%, whenever someone deposits $1000 at a commercial bank, the bank must keep $100 in their reserves.

In this way, the Fed requires a portion of each bank's deposits to be kept in reserve and not used to make loans. This requirement is in case there is a withdrawal request by clients who want to remove their funds from the bank. The bank must have the funds available to provide to their clients; otherwise, it would cause panic in the market.

When the banks don’t have the necessary reserves, these individual banks borrow money in the federal funds market in order to meet the reserve requirement and avoid repercussions. The federal funds market is an inter-bank financial market that allows banks to borrow money overnight.

Discount rate

The discount rate refers to the rate at which banks that need reserves can borrow from the Fed itself. The discount rate is set above the federal funds rate so that banks borrow from the Fed only when the federal funds market is maxed out.

The discount rate is expressed in terms of percentage points above the federal funds rate. Typically set at 1%, the discount rate was lowered to .25% during the financial crisis in the U.S. in the spring of 2008.

The discount rate is used by the Fed as a tool to control the money supply in the economy, and ultimately the overall consumption and investment. When the discount rate is lower, banks can more cheaply borrow money from the Fed. This enables banks to lend more money out to potential borrowers, which injects more money into the economy. The additional borrowing allows consumers to increase their consumption and allows businesses to increase investments.

On the other hand, if the Fed decides to increase the discount rate, then banks have to pay a higher interest rate for every dollar they borrow, which means those banks have fewer dollars available to lend to their own potential borrowers. Thus, the money supply will fall, as banks will be discouraged from lending money. Ultimately, the Fed expects this will decrease overall consumption and investment.

Open-market operations

The Federal Reserve's Open-Market Committee (FOMC) is the entity that conducts these open-market operations. Open-market operations refer to the buying and selling of U.S. government debts by the Fed.

The FOMC buys government securities, and treasury bills, but not directly from the U.S. government. Instead, the FOMC buys these assets from other financial institutions. The reason for that is to prevent the Fed from financing government debt just by printing more money.

When the Fed buys treasury bills, the Fed takes dollars out of the national reserves to purchase the treasury bills, and those dollars represent an increase in the amount of money circulating in the economy. On the other hand, when the

Fed sells treasury bills, in these public markets, the Fed is taking money out of the economy and returning it to the national reserves. As a consequence, the money circulating in the economy shrinks.

The FOMC operates by first determining the federal funds rate that it thinks would be beneficial for the economy. The federal funds rate is set by supply and demand in the federal funds market, but the FOMC then buys and sells treasuries in an effort to steer the economy toward the target federal funds rate.

Importance of the Federal Reserve

Through the performance of all of its various responsibilities and functions, such as setting interest rates, regulating financial institutions, and controlling the money supply, the Federal Reserve contributes significantly to the preservation of the economy's health, particularly during times of economic crisis.

A key important role of the Federal Reserve System is to control the money supply, which affects consumption and investment, and ultimately maintains price stability in the market. Other key roles include making sure that the dollar maintains its value and that the economy doesn't slip into an irreversible crisis.

Imagine if you woke up in the morning and saw that aggregate prices doubled last night whilst you were sleeping! It's unthinkable, right? Well, many developing countries experience such high inflation levels. These cases demonstrate the importance of a central banking system like the Federal Reserve.

Even during times of economic expansion, the actions taken by the Federal Reserve, and the measures taken in response to those activities, can have a genuine and significant influence on your day-to-day life. Changes in interest rates have direct consequences, such as higher or lower consumer interest rates. Other consequences, such as swings in stock values, are indirect. Changes in interest rates can affect the value of other assets like your pension fund, savings fund, housing prices, basically all aspects of your life.