Purpose and Function of The Federal Reserve I. The History of The Federal Reserve A. Financial Panics B. Federal Reserve Act C. Structure and Focus II. Federal Reserve Board A. FRB Members B. Federal Open Market Committee C. FOMC Members III. Federal Reserve System A. Monetary System Work B. Federal Reserve Banks IV. Four Basic Functions of the Federal Reserve A. Monetary Policy B. Regulating Financial Institutions C. Serving as Banker D. Payment Services V. Monetary Policy Function A. Main Purpose B. Influence Over C. FOMC Meetings VI. Open Market Operations A. Definition B. Examples C. Limitations VII. Discount Rate A. Definition B. Original Design VIII. Reserve Requirement A. Definition B. Explanation C. Federal Funds Rate D. Y2K Concerns IX. Public/Private Structure of Fed A. Representation B. Funding C. Ownership X. System Policy Objectives / Conclusion The Purpose and Function of The Federal Reserve Before Congress created the Federal Reserve System, the United States had been plagued by severe booms and busts and financial panics, which contributed to many business bankruptcies, bank failures and economic downturns. In 1907 yet another crisis prompted Congress to create some kind of an institution that would counter these kinds of financial disruptions, and bring Federal oversight to a largely unregulated banking system. The Federal Reserve Act was passed by Congress and President Woodrow Wilson signed it into law on December 23, 1913. Its purpose was to establish Federal reserve banks, to establish a more effective supervision of banking in the United States, to keep our money valuable, and to give the nation a more flexible and stable monetary and financial system. It was structured as an American version of a central bank, with Reserve Banks and branches in 12 districts across the country, coordinated by a Board of Governors in Washington, D.C. and would carry out the constitutional mandate of Congress to coin money and regulate the value thereof. The Federal Reserve System is commonly called The Fed, is known as the central bank of the United States, and over the years its role in the economy and banking has expanded, but its focus is still the same. The Federal Reserve Board is made up of seven Presidential appointees, including the Fed Chairman, whose terms are 14 years in length. Their job is to govern the Federal Reserve System. Its members also serve on the Federal Open Market Committee (FOMC), which sets monetary policy. The other members of the FOMC include 5 presidents of the 12 district Federal Reserve Banks. The Federal Reserve System does the work that is necessary in any monetary system. It processes checks, serves as a clearinghouse for bank transactions, processes Treasury securities transactions, and lends money. It determines the interest rate for loans to commercial banks, selects the required reserve ratio which determines how much customer deposits a bank must keep on hand (which affects how much new credit the bank can create ), and also decides how much new currency Federal Reserve Banks may issue each year. It releases coins and currency notes produced by the Treasury Department, to the commercial banking system. The demand for money by the public varies from day to day and from week to week. There are even differences from season to season. Banks are usually first to feel the impact of the public s demand for cash. To meet these needs, banks turn to their regional Federal Reserve bank for coins and currency when their supplies are low. The Federal Reserve Banks are used to clear checks, to lend money to banks that are temporarily strapped for reserves, to issue currency, and to hold reserve deposits of member banks. Today the Fed has four basic functions: 1) Conducting the nation s monetary policy by influencing the supply of money and credit. 2) Regulating and supervising financial institutions, banking operations and protecting the credit rights of consumers. 3) Serving as banker and fiscal agency for the United States Government. 4) Supplying payment services to the public through depository institutions. All four roles are important in maintaining a stable growing economy, but influencing the supply of money and credit — the monetary policy function — is the most important and probably the function with which people are most familiar. Monetary policy is the strategic actions taken by the Federal Reserve to influence the supply of money and credit in order to foster price stability and maintain economic growth. In this way, the Fed helps keep our national economy strong and the world economy stable. This influence over monetary policy is the Fed s real authority, and the reason for its enormous prominence in the financial world. The Fed s main purpose regarding monetary policy is to ensure that enough money and credit are available to sustain economic growth without inflation. If there are signs that inflation is threatening our purchasing power, the Fed may need to slow the growth of the money supply. It does this by using three tools – the discount rate, reserve requirements and most important, open market operations. Two main committees direct Fed policies. They are the Board of Governors and the Federal Open Market Committee. Two other organizations assist the Fed Board. The Federal Advisory Council advises the board on business and financial conditions, and the Consumer Advisory Council advises the board on its responsibilities under consumer credit protection laws. The influence over monetary policy is exercised by the Federal Open Market Committee (FOMC) which sets the Fed policy for trading government securities ( Treasury bills, Treasury bonds and Treasury notes) and is responsible for open market operations. The committee consists of the Board of Governors, the president of the Federal Reserve Bank of New York and four other Reserve Bank presidents who serve on a rotating basis, although all members participate fully
in deliberations. The FOMC meets eight times a year. The meetings usually feature summaries of international economic developments, reports on conditions in the domestic financial markets and the banking system, and a presentation on the U.S. economy as a whole, and a forecast for the future. Policy options are discussed and votes are taken to decide whether or not the Fed will act. Reserve Bank boards of directors, research departments and regional business leaders contribute grassroots information and insight that are used to formulate monetary policy. Both the public and the private sectors contribute to these decisions. Open market operations is the buying and selling of United States Government securities on the open market for the purpose of influencing short term interest rates and the growth of money and credit. Whenever an increase in the growth rate of the money supply and credit is needed, or if downward pressure on short-term interest rates is desired, the Fed buys securities from brokers or dealers, which adds money to the reserve accounts of the banks of the brokers or dealers. Then the banks credit the accounts of the brokers and dealers, which increases the amount of money and credit available in the market. Whenever the growth of money and credit needs to be slowed down, the Fed sends securities to brokers and dealers, taking payment by debiting the accounts of banks of the brokers and dealers. Reserves leave the banking system which reduces the money supply and cuts back the expansion of credit. Even though the Fed has enormous influence over the financial markets, it cannot force banks to raise or lower interest rates, which have remained at historically high levels ever since the early 1980 s. The Fed doesn t control the market, but it does hold sway over short-term interest rates – because that is what is affected by its open market operations. It is a vital participant in providing a strong central bank during times of crisis. The discount rate is the interest rate at which banks can borrow from the Federal Reserve System for short-term liquidity needs. The discount rate is changed infrequently and can discourage or encourage financial institutions lending and investment activities. It is usually lower than the Federal Funds Rate because troubled institutions can borrow to get them through short periods of problems. Originally, it was designed to help end runs on the bank. Banks only borrow in this way if they need the help. The reserve requirement is the percentage of deposits in demand deposit accounts that financial institutions must set aside and hold in reserve. If the Fed raises the reserve requirement, banks have less money to lend, which slows the growth of the money supply. If the Fed lowers the reserve requirement, banks have more money to lend and the money supply increases. The Federal Reserve System is responsible for providing the total amount of reserves consistent with the monetary needs of the economy at reasonably stable prices. Changes in the volume of reserves influence the money supply, the availability of credit, interest rates, and as a result, the volume of spending. Depository institutions feel the impact of changes first, but the effects spread quickly to the entire financial structure of the nation, the domestic economy and often to the international economy as well. The Fed can raise or lower the Federal Funds Rate, which is the interest rate banks charge each other for overnight credit. Banks that have excess reserves will lend their reserves to other banks who don t have enough cash on hand to meet their reserve requirements. For example, the Federal Funds Rate might go up during the Christmas holidays when many people are withdrawing above normal amounts of cash for shopping. In August of 1998, as a precautionary measure, the Federal Reserve made plans to stock up on cash in case nervous Americans want more of it in their pockets on the eve of the year 2000. The concern is that people might worry about whether credit cards and automated teller machines will still work after the new century dawns because many older computers read years by the last two digits and would interpret 2000 as 1900. Federal Reserve officials want to make sure teller windows are well-supplied with cash if people decide they want it. The Fed has a unique public/private structure that operates independently within the government but not independent of it. The Board of Governors, appointed by the president of the United States and confirmed by the Senate, represents the public sector, or governmental side of the Fed. The Reserve Banks and the local citizens on their boards of directors represent the private sector, and provide grassroots economic information. In this way accountability is provided and governmental control of banking and monetary policy is avoided. The Federal Reserve is fiscally independent because it receives no government appropriations. The Fed funds its activities with the interest earned from loans to banks, investment in governmental securities, and from the revenue received from providing services to financial institutions. Their goal in providing services is to generate only enough revenue to cover costs. Alarmists contend that the Federal Reserve is privately owned and has complete and absolute control over our money, and that each year billions of dollars are earned by its stock holders. The Fed is set up like a private corporation, and member banks hold its stock, but less than one percent of the Fed s net earnings are distributed as dividends so it seems that a member bank could easily find a much more profitable investment than buying Federal Reserve Stock. Any excess money is turned over to the U.S. Treasury, and has been since 1947. The Fed owes its existence to an act of Congress and has a mandate to serve the public, so the reasonable view is that the Federal Reserve is owned by the citizens of the United States. The Federal Reserve System policy objectives support the nation s primary economic goals: high employment, stable prices, economic growth, and balance in international accounts. While the Federal Reserve System alone cannot achieve these goals, it can do a great deal to foster a monetary and credit climate conducive to their attainment. List of Works Consulted Galbraith, John Kenneth. The Great Crash 1929. Boston: Houghton Mifflin Company, 1979. Greenwald, Carol S. Federal Reserve System. The world Book Encyclopedia, 1992. Greider, William. Secrets of The Temple: How The Federal Reserve Runs the Country. New York: Simon and Schuster, 1987. Malkin, Lawrence. The National Debt. New York: Henry Holt and Company, 1987. Stinebrickner, Bruce, editor, American Government 98/99. Connecticut: Dushkin / McGraw Hill, 1998. Wolf, Harold A. The Monetary System of the United States. Encyclopedia Americana, 1995.