This Web site is an "Introduction To The Federal Reserve."
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The Federal Reserve - The Central Bank of the U. S.
This is part of a larger bond and interest rate site provided by Equity
Analytics, Ltd.
This section is written to provide an overview of the Federal Reserve in
the United States. The Federal Reserve System is the central bank of the
United States. In 1913 Congress created the Federal Reserve. The Fed is
charged with the responsibility to foster a sound banking system and a
healthy economy. Today the Fed is comprised of 12 regional Federal Reserve
Banks and the Board of Governors in Washington, D.C. The acts in different
roles in our financial system. It serves as a banker's bank, as the
government's bank, as a regulator of financial institutions, and as the
nation's money manager.
The Federal Reserve was created out of a need to avoid the cyclical
pattern of booms and busts that the U.S. economy had been experiencing.
After a long drawn out battle in Congress and the public, a compromise was
reached. And in 1913, Congress created the Federal Reserve System. It is a
fairly complicated structure. However, it is through this structure that
the Fed is able to insulate itself from narrow, partisan needs and
desires. The Fed's mission - to foster a sound and healthy financial
system and economy.
As a banker's bank, the Fed's 12 regional Banks provide services to
financial institutions that are similar to the services that banks and
thrifts provide to businesses and individuals. The payments system is
where all financial transactions in the economy flow. The Fed helps assure
the safety and efficiency of the payments system.
Fed processes millions of payments every day in the form of both paper
checks and electronic transfers. When an individual cashes a check or has
money electronically, it is most likely the Federal Reserve Bank which
will handle the transfer of funds from one financial institution to
another. This is a fee based service the Fed Banks offer the depository
institutions in its Federal Reserve District. Institutions can choose to
use the Fed's services or those offered by other competitors in the
marketplace.
The 12 Fed Banks process more than one-third of the $12 trillion in checks
written annually in the U.S. The dollar volume transferred through the
Federal Reserve's electronic network approaches $200 trillion which is far
larger than the gross national product of the United States.
The Federal Reserve also acts as the government's bank. In its role as the
government's bank or fiscal agent, the Fed processes a variety of
financial transactions involving trillions of dollars. The U.S. Treasury
keeps a checking account with the Federal Reserve. This checking account
is used for incoming federal tax deposits and outgoing government
payments. As part of its relationship with the U.S. government, the Fed
sells and redeems U.S. government securities such as savings bonds and
Treasury bills, notes, and bonds.
The coin and paper currency of the United States is also issued by the
Federal Reserve. The currency is actually produced by the U.S. Treasury,
through its Bureau of the Mint and Bureau of Engraving and Printing. The
currency is then distributed by the Federal Reserve Regional Banks to
financial institutions. Periodically, the currency circulates back to the
Fed Banks where it is counted, checked for wear and tear, and examined for
counterfeits. If the money is still in good condition, it is eventually
sent back into circulation as institutions order new supplies to satisfy
the public's need for cash. Worn-out bills, are destroyed by shredding.
The average $1 bill circulates for approximately 18 months before it is
destroyed.
The Federal Reserve supervises and regulates financial institutions.
Financial institutions are governed by the rules that the Fed formulates.
To help ensure financial institutions operate in a safe and sound manner
and comply with the laws and rules that apply to them, there are rigorous
examination and monitoring procedures that the Fed uses. The examination
and monitoring duties are carried out by the regional Federal Reserve
Banks.
Banks that are seeking to merge or bank holding companies seeking to buy a
bank or engage in a non-banking activity, must receive approval from the
Fed. One of the major considerations the Fed takes into account when
approving or disapproving a merger is how the transaction will affect
competition in the local community. Additionally, the Federal Reserve also
implements laws--such as Truth-in-Lending, Equal Credit Opportunity, and
Home Mortgage Disclosure, meant to ensure that consumers are treated
fairly in financial dealings.
The Fed is also the "lender of last resort". Financial institutions can
turn to the Federal Reserve if they are experiencing a significant and
unexpected drain on their deposits and can't borrow money elsewhere. The
purpose of this lending ability is to prevent one institutions problems
from spreading to other financial institutions and possibly destabilizing
the banking system.
The Federal Reserve is structured in layers. The central bank sits on top.
Comprising the central bank is the Board of Governors. The Board of
Governors has 7 members each serving staggered 14 year terms. Each member
of the Board of Governors is appointed by the President and must be
confirmed by the Senate. The Board of Governors oversees the entire System
operations, it makes regulatory decisions, and sets reserve requirements
for banks.
There are 12 regional Federal Reserve Banks. Each of these banks is
comprised of a 9 member board of directors drawn from the private sector.
And each of these 12 banks is independently incorporated. These banks set
the discount rate, subject to approval by the Board of Governors. And
region by region, they monitor the economy and the financial institutions
in their respective region.
The Federal Open Market Committee (FOMC) is the body inside the Fed which
is responsible for key monetary policymaking. The Fed seeks to foster
economic growth with price stability. This is done by making decisions
which affect the flow of money and credit in the United States. The
Federal Open Market Committee is comprised of the 7 members of the Board
of Governors and the Reserve Bank presidents, 5 of whom serve as voting
members on a rotating basis.
The primary responsibility of the Fed is in formulating and carrying out
monetary policy. In order to carry out monetary policy, the Fed acts as
the nation's "money manager". The Fed tries to balance the flow of money
and credit with the needs of the economy. Too much money in the economy
can lead to inflation, while too little can stifle economic growth. The
Fed seeks to strike a balance between these two extremes.
In order to balance the flow of money, the Fed affects the ability of
financial institutions to "create" checkbook money through loans or
investments. This is accomplished by determining the amount of "reserves"
that banks and thrifts must hold.
Depository institutions are subject to rules requiring that a certain
percentage of their deposits be set aside as reserves and not used for
loans or investments. Banks and thrifts can keep cash in their own vaults
and through balances held in a reserve account at a regional Federal
Reserve Bank. If a bank or thrift has to keep more cash in reserve, they
have less to lend to the public. Through the reserve requirement, the Fed
indirectly affects the flow of money and credit through the economy.
The Fed can affect the reserves through 3 methods. The first of these is
reserve requirements. A higher reserve requirement leads to banks and
thrifts keeping more money in reserve and less money by banks available to
lend and invest. A lower reserve requirement means that the banks and
thrifts have to keep less money and reserve. Therefore, they have more
money to lend and invest. Changing the reserve requirement can have a
dramatic affect on the economy is used sparingly by the Fed.
The discount rate is the second method the Fed has to alter the money
supply in the economy. The discount rate is the rate at which banks and
thrifts can borrow on an overnight basis from the Fed. By making it more
expensive for banks and thrifts to borrow overnight the Fed can make it
more expensive to obtain money. Thereby, it can inhibit bank lending and
investment. The problem with this is that if funds are readily available
from other sources to banks and thrifts, this has a very small effect. It
is used more to signal future Fed direction than to slow down lending and
investment.
The third method the Fed has at its disposal to influence the money supply
is through open market operations. This is the most flexible of the three
tools. Open market operations involve the he purchase and sale of
government securities by the Fed. When the Fed wants to increase the flow
of money and credit, it buys government securities; when it wants to
restrict the flow of money and credit, it sells government securities.
Open market operations affect the supply of money through the reserves of
depository institutions. If, the Federal Reserve wanted to increase the
supply of money and credit, it might purchase $10 billion in government
securities from a few securities dealers. The purchase would be paid for
by the Federal Reserve. The Fed would pay for the securities by adding $10
billion to the reserve accounts that the security dealer's bank keeps at
the Fed. The bank would in turn credit the security dealer's account for
that amount. The dealer's bank must keep a certain percentage of these new
funds in reserve. However, it can lend and invest the remainder. As these
funds are spent and re-spent, the stock of money and credit will
eventually increase by much more than the original $10 billion addition.
If the Fed wanted to decrease the money supply, it would sell $10 billion
in government securities to several dealers. That amount would be deducted
from the reserve accounts of the dealers banks. The bank, would deduct $10
billion from the accounts of the dealers. Less money would end up flowing
through the economy.
Like the rest of the United States Government, the Fed has certain checks
and balances within it to limit the power any one group inside the Fed can
wield. Each group inside the Fed has a different authority to act. Only
the Board of Governors can change the reserve requirements. Subject to
approval by the Federal Reserve Board of Governors, the Regional Federal
Reserve Banks have the authority to change the discount rate. And open
market operations, which many consider to be the most important tool, are
directed by the Federal Open Market Committee (FOMC).
The Federal Open Market Committee (FOMC), is possibly the most important
policymaking body. It is comprised of all 7 members of the Board of
Governors and the presidents of the Reserve Banks. Only 5 of the 12
presidents serve as voting members. The president of the New York Fed,
which handles the open market securities transactions on behalf of the
System, serves as a permanent voting member, while the other presidents
rotate annually. Even though only 5 presidents vote, all 12 participate
fully in each FOMC meeting.
The Fed is an interesting central bank. In fact, it is like no other
central bank. It is a central bank, but it is decentralized with a system
of regional Reserve Banks responsive to local needs. It is a public
institution with a public purpose, but it has some private features such
as, directors, "stockholders," and selling services. It is governmental,
but it is independent within government. It was created by and reports to
Congress. However, its highest officials, the members of the Board of
Governors, are appointed by the President and confirmed by the Senate. Its
earnings and assets are returned to the U.S. Treasury. The Fed operates
on its own earnings rather than Congressional appropriation. The Board of
Governors terms are long and staggered, limiting the President's
influence. And unlike other nations central banks, it is separate from the
Treasury.
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