Federal Reserve System


Federal Reserve System Essay, Research Paper

Saint Leo?s University



Joan Mierzwa

June 21, 2000




II. Federal Reserve System-Overview 5

III. History of the Federal Reserve Act and Amendments to 8

IV. Structure of the System 9

V. Board of Governors 10

VI. Monetary Policy and Effects of on the Economy 12

VII. Final Thoughts



Why do a report on the Federal Reserve System? This is a question I went over in my head while making a decision on the type of report to do, and what I wanted to learn more about and why.

Over the past few years I have realized the impact that the Federal Government has on our economy, yet I never knew enough about the subject to understand why. While taking this Economics course it has brought so many things to my attention, especially since I see inflation, gas prices, and interest rates on the rise. It has given me a better understanding of the affect of the Government on the economy, the stock market, the interest rates, etc. Since the Federal Government has such a control over our Economy, I decided to tackle the subject of the Federal Reserve System and try to get a better understanding of the history, the structure, and the monetary policy of the power that it holds.


The Federal Reserve System is the central banking authority of the United States. It acts as a fiscal agent for the United States government and is custodian of the reserve accounts commercial banks, makes loans to commercial banks, and is authorized to issue Federal Reserve notes that constitute the entire supply of paper currency of the country. Created by the Federal Reserve Act of 1913, the 12 Federal Reserve banks, the Federal Open Market Committee, and the Federal Advisory Council, and since 1976, a Consumer Advisory Council which includes several thousand member banks.

The board of Governors of the Federal Reserve System determines the reserve requirements of the member banks within statutory limits, reviews and determines the discount rates established pursuant to the Federal Reserve Act to serve the public interest; it is governed by a board of nine directors, six of whom are elected by the member banks and three of whom are appointed by the Board of Governors of the Federal Reserve System. The Federal Reserve banks are located in Boston, New York, Philadelphia, Chicago, San Francisco, Cleveland, Ohio; Richmond, Virginia; Atlanta, Georgia; Saint Louis, Mo.; Minneapolis, Minnesota; Kansas City, Mo.; and Dallas Texas. The Federal Open Market Committee, consisting of the seven members of the Board of Governors and five members elected by the Federal Reserve banks, is responsible for the determination of Federal Reserve Bank policy in the purchase and sale of securities on the open market. The Federal Advisory Council, whose role is purely advisory, consists of 12 members if the meet membership qualifications.

The Federal Reserve System exercises its regulatory powers in several ways, the most important of which may be classified as instruments of direct or indirect control. One form of direct control can be exercised by adjusting the legal reserve ratio (the proportion of its deposits that a member bank must hold in its reserve account), and as a result, increasing or decreasing the amount of new loans that the commercial banks can make. Because loans give rise to new deposits, the possible money supply is, in this way, expanded or reduced. This policy tool has not been used too much in recent years.

The money supply may also be influenced through manipulation of the discount rate, which is the rate if interest charged by the Federal Reserve banks on short-term secured loans to member banks. Since these loans are typically sought to maintain reserves at their required level, an increase in the cost of such loans has an effect similar to that of increasing the reserve requirement.

The classic method of indirect control is through open-market operations, first widely used in the 1920s and now used daily to make some adjustment to the market. Federal Reserve bank sales or purchases of securities on the open market tend to reduce or increase the size of commercial bank reserves. (When the Federal Reserve sells securities, the purchasers pay for them with checks drawn on their deposits, thereby reducing the reserves of the banks on which the checks are drawn.

The three instruments of control explained above have been conceded to be more effective in preventing inflation in times of high economic activity than in bring about revival from a period of depression. Another control occasionally used by the Federal Reserve Board is that of changing the margin requirements involved in the purchase of securities.

The Federal Reserve System was founded by Congress in 1913 to provide the nation with a safer, more flexible and more stable monetary and financial system. Over the years its role in banking and the economy has expanded. Today the Federal Reserve?s Duties fall into four general areas:

? Conducting the nation?s monetary policy by influencing the money and credit conditions in the economy in pursuit of full employment and stable prices.

? Supervising and regulating banking institutions to ensure the safety and soundness of the nation?s banking and financial system to protect the credit rights of consumers.

? Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.

? Providing certain financial services to the United States government, the public, financial institutions, and to foreign official institutions, including playing a major role in operating the nation?s payments system.


Before Congress created the Federal Reserve System, periodic financial panics had plagued the nation. These panics had contributed to many bank failures, business bankruptcies, and general economic downturns. A severe crisis in 1907 prompted Congress to establish the National Monetary Commission, which put forth proposals to create an institution that would counter financial disruptions of these kinds. After much debate, Congress passed the Reserve Act, which was signed into law by President Woodrow Wilson, on December 23, 1913. The Act stated that its purpose was to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of discounting commercial paper, to establish a more effective supervision of banking in the United States, and for other reasons.

Soon after the creation of the Federal Reserve, it became clear that the act had broader implications for national economic and financial policy. As time has passed, further legislation has clarified and supplemented the original purposes. Key laws affecting the Federal Reserve have been the Banking Act of 1935, the Employment Act of 1946, the 1970 amendments to the Bank Holding Company Act; the International Banking Act of 1978, the Full Employment and Balanced Growth Act of 1978, the Depository Institutions Deregulation and Monetary Control Act of 1980, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, and the Federal Deposit Insurance Corporation Act of 1991. Congress defines the primary objectives of national economic policy in two of these acts: the Employment Act of 1946 and the Full Employment and Balanced Growth Act of 1946. These objectives include economic growth in line with the economy?s potential to expand; a high level of employment; stable prices and moderate long-term interest rates. The Federal Reserve System is considered to be an independent central bank. It is so, however, only in the sense that its decisions do not have to be ratified by the President or anyone else in the executive branch of government. The entire System is subject to oversight by the United States Congress because the Constitution gives to Congress, the power to coin money and its value-a power that, in the 1913 act, Congress itself delegated to the Federal Reserve. The Federal Reserve must work within the framework of the overall objectives of economic and financial policy established by the government, and thus the description of the System as ?independent within the government? is more accurate.


The Federal Reserve System has a structure designed by Congress to give it a broad perspective on the economy and on economic activity in all parts of the nation. It is a federal system, composed basically of a central, governmental agency-the Board of Governors-in Washington D.C., and twelve regional Federal Reserve Banks, located in major cities throughout the nation. These components share responsibility for supervising and regulating certain financial institutions and activities; for providing banking services to depository institutions and to the federal government; and for ensuring that consumers receive adequate information and fair treatment in the business with the banking system.

A major component of the System is the Federal Open Market Committee (FOMC), which is made up of the Board of Governors, the president of the Federal Reserve Bank of New York, and presidents of four other Federal Reserve Banks, who serve on a rotating basis, The FOMC oversees open market operations, which is the main tool used by the Federal Reserve to influence money market conditions and the growth of money and credit.

Two other groups play roles in the way the Federal Reserve System works; depository institutions, through which the tools of monetary policy operate, and advisory committees, which make recommendations to the Board of Governors and to the Reserve Bans regarding the System?s responsibilities.

The Board of Governors

The Board of Governors of the Federal Reserve System was established as a federal government agency. It is made up of seven members appointed by the President of the United States and confirmed by the United States Senate. The full term of a Board member is fourteen years; the appointments are staggered so that one term expires on January 31 of each even-numbered year. After serving a full term, A board member may not be reappointed, If a member leaves the Board before his or her term expires, however, the person appointed and confirmed to serve the remainder of the term may later be reappointed to a full term.

The Chairman and Vice Chairman of the board are also appointed by the President and confirmed by the Senate. The nominees to these posts must already be members of the Board or must be simultaneously appointed to the Board. The terms for these positions are four years.

A Washington staff of about 1,700 supports the Board of Governors. The Board?s responsibilities require thorough analysis of domestic and international financial and economic developments. The Board carries out those responsibilities in conjunction with other components of the Federal Reserve System. It also supervises and regulates the operations of the Federal Reserve Banks and their Branches and the activities of various banking organizations, exercises broad responsibility in the nation?s payments system, and administers most of the nation?s laws regarding consumer credit protection.

The Federal Reserve System conducts monetary policy using three major tools:

? Open market operations-the buying and selling of U.S. government (mainly Treasury) securities in the open market to influence the level of reserves in the depository system.

? Reserve requirements-requirements regarding the amount of funds that commercial banks and other depository institutions must hold in reserve against deposits.

? The discount rate-the interest rate charged commercial banks and other depository institutions when they borrow reserves from a regional Federal Reserve.

Policy regarding open market operations is established by the FOMC. However, the Board of Governors has sole authority over changes in reserve requirements, and it must also approve any change in the discount rate initiated by a Federal Reserve Bank.

The Federal Reserve also plays a major role in the supervision and regulation of the U.S. banking system. Banking supervision-the examination of institutions for safety and soundness and for compliance with law-is shared with the Office of the Comptroller of the Currency, which supervises national banks and the Federal Deposit Insurance Corporation, which supervises state banks that are not members of the Federal Reserve System. The Board?s supervisory responsibilities extend to the roughly 1,000 state bands that are members of the Federal Reserve System, all bank holding companies, the foreign activities of member banks, the U.S. activities of foreign banks, and Edge Act and agreement corporations (the institutions that engage in a foreign banking business).

Monetary Policy and Effects of on the Economy

Using tools of monetary policy, the Federal Reserve can affect the volume of money and credit and their price-interest rates. In this way it influences employment, output, and the general level of prices. The Federal Reserve Act lays out the goals of monetary policy; the Federal Reserve System and The Federal Open Market Committee should seek ?to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.?

Monetary policy works through the market for reserves and involves the federal funds rate. A change in the reserves market will trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit in the economy, and levels of employment, output and prices. For example, if the Federal Reserve reduces the supply of reserves, the resulting increase in the federal funds rate tends to spread quickly to other short-term market interest rates, such as those on Treasury Bills and commercial paper. A change in short-term rates will also translate into changes in long-term rates on such financial instruments as mortgages, corporate bonds, treasury bonds, especially if the change in short-term rates is expected to persist. A rise in short-term rates that is expected to continue will lead to a rise in long-term rates.

Higher ling-term interest rates will reduce the demand for items that are most sensitive to interest cost, such as housing, business investment, and durable consumer goods. Higher mortgage rates depress the demand for housing, Higher corporate bond rates increase the cost of borrowing for businesses and thus, restrain the demand for additions to plants and equipment; and tighter supplies of bank credit may constrain the demand for investment goods by those firms particularly dependent on bank loans. Higher interest rates also reduce consumer demand for such items as cars, and they also will effect the value of household assets-such as stocks, bonds, and land. The implications of changes in interest rates extend beyond domestic money and credit markets. If the interest rates in the U.S. move higher in relation to those abroad, holding assets denominated in U.S. dollars become more appealing, and the demand for dollars in foreign exchange markets increases. A result is upward pressure on the exchange value of the dollar. With flexible exchange rates the dollars strengthens, the cost of imported goods to Americans declines, and the price of U.S. produced goods to people abroad rises. As a consequence, demands for U.S. goods are reduced as Americans are induced to substitute goods from abroad for those produced in the United States and people abroad are induced to buy fewer American goods. Such changes in the demand for goods and services get translated into changes in total production and prices.

Closing Thoughts

There are so many different views on the impact that the Federal Reserve has on the National and Global Economy. Many feel that the Fed generally lowers rates to stimulate consumption and lowering rates would prevent the U.S. from becoming part of a global slump. A rise in rates is typically matched by the prime rate set by banks and by short-term interest on Treasuries. Eventually, those higher rates brake the economy?and cool inflationary tendencies. There are these that actually feel that those who control this country?s money inherently control this country. They feel that ? to 1% of the population rules the other 99 to 99.5% of the population. They say that rulership is achieved through direct control of this nation?s private economy, In addition, the elite of U.S. society controls the national communications media as well as the executive branch of the federal government by virtue of the Federal Reserve.

I feel that the latter is on the radical side of thinking, and that overall the Federal Reserve has the best interest of the nation and international economy in all their decisions regarding the increases in interest rates, etc. Since the onset of the Federal Reserve we have not gone into a depression, and over a course of time there will be times when our economy will peak and boom and the Fed will feel that it is time to slow the economy by raising the rates, as in the course of the last six months.


A Monetary History of the United States, 1867-1960

By Milton Friedman and Anna Jacobson Schwartz, Princeton, 1963 last printing 1993

Managerial Economics, Thomas Hailstones and John Rothwell, Prentice Hall, 1985

Encyclopedia Britannica





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