Federal Reserve System

What It Means

All modern capitalist nations have central banks. In the United States the central bank is called the Federal Reserve System, or the Fed; it is an independent agency of the U.S. government. Most large banks in the United States belong to the Federal Reserve System. That is, they have accounts with the Fed that are almost exactly like the accounts individual people have with their banks. Member banks deposit checks and maintain a balance (an amount of money) with the Fed. But even those banks that are not Fed members must obey the banking rules set by the Fed, which regulates the entire industry. The Fed also serves as a bank for the U.S. government itself and oversees the circulation of hard currency (paper bills and coins). The Fed’s most important and complicated duty, however, is the setting of U.S. monetary policy: the Fed decides whether, when, and how to change the money supply (the amount of money circulating in the U.S. economy).

The size of the money supply affects all facets of the economy, and it has a direct link to inflation (the general rising of prices), which can cause a nation’s money to lose its value. The Fed monitors the economy and makes decisions about whether the U.S. money supply should be increased, decreased, or left alone. When it decides to change the size of the money supply, it does so by influencing banks and their ability to make loans.

When Did It Begin

The Federal Reserve System was created by the Federal Reserve Act of 1913, which was introduced in order to strengthen the U.S. banking system. Prior to 1913 individual banks made their own decisions about how much hard currency to keep on hand (in reserve) in case depositors (bank account holders) wanted to withdraw some or all of their account balances in cash. The banks made the rest of the money people deposited with them available for loan, charging interest (fees imposed for the use of borrowed money) in order to make profits. But the amounts of money that banks reserve and loan out directly determine how much money is circulating in the economy; thus uncertainty about reserve levels and other banking issues leaves the economy vulnerable to economic catastrophe of all kinds, including bank failures, or bank runs, when people lose faith in the system, and everyone demands their money at once (money that the banks do not have on hand). Numerous bank failures led to what became known as the panic of 1907, an economic crisis during which the stock market slumped, millions of bank account holders lost their savings, and many other banks and business firms closed down. By centralizing and stabilizing the banking system with the Federal Reserve Act, the U.S. government was able to take direct control over the money supply, one of the most important factors in the overall health of the economy.

More Detailed Information

The Fed’s most important function is the regulation of the country’s money supply. The Fed does not, however, simply order new dollar bills printed or pull old dollar bills out of the flow when it wants to change the amount of money in circulation. Instead, the Fed controls the money supply by setting rules for and influencing the practices of banks. To understand how this happens, it is first necessary to understand the way the banking system works.

All modern economies are driven by a fractional-reserve banking system, which means that at any given time banks possess hard currency amounting to only a fraction of the money that has been deposited by account holders. Fractional banking makes a great deal of economic activity possible that would be impossible if everyone needed cash for all purchases. In fact, fractional banking creates money that would not otherwise exist.

For instance, assume that Jane Doe deposits $10,000 in Bank X. Bank X will want to loan most of that money out so that it can collect interest and make a profit. Say that Bank X puts $1,000 of Jane’s total $10,000 in reserve and loans the remaining $9,000 to John Smith, who wants to open a coffee shop. Bank X will give John Smith a checkbook tied to a checking account with his $9,000 in it, and he will use his Bank X checks to pay Big Time Coffee Distributing, Inc. for $9,000 worth of tables, chairs, coffee makers, and coffee. Big Time will deposit John Smith’s $9,000 worth of checks at its own bank, Bank Y; then Bank Y will set aside $900 while making the remainder ($8,100) available for loans. Say that Mary Brown shows up at Bank Y asking for $8,100 to open a sandwich shop. The process described above will continue as Mary Brown writes checks that are deposited in yet another bank, and so on, through other individuals and banks, until the original $10,000 is used up. At that point there will be far more than $10,000 in circulation.

Though it would be more complicated in reality, the above scenario describes the process by which banks literally create money. The Fed can, therefore, expand or restrict the money supply by influencing this process. It has three basic methods for doing so.

First, the Fed can simply change the percentage of deposits banks are required to keep in reserve. The above example assumes banks are required to reserve 10 percent of all deposits. If Bank X had been required to keep 15 percent of Jane Doe’s deposit in reserve ($1,500), it would have been able to lend only $8,500 to John Smith, and this would have reduced the amount of money ultimately created by the chain of borrowers, businesses, and lenders involved. Likewise, if Bank X had to set aside only 5 percent of Jane’s deposit ($500), the amount of money created would be increased. Although the Fed has the ability to modify the reserve requirement to affect lending behavior, in practice it rarely, if ever, makes use of this policy tool.

The Fed’s second means of influencing the money supply is to change the interest rate it charges member banks to borrow money (this interest rate is called the discount rate). For instance, if Jane Doe had not made a $10,000 deposit, Bank X could still make a $9,000 loan to John Smith by borrowing enough money from the Fed to cover its reserve requirements (which would be $1,000 if the required reserve rate were 10 percent). If the Fed was currently charging a low price for this borrowed money (a low discount rate), Bank X would be likely to borrow from the Fed and, in turn, loan money to John Smith. If, however, the Fed was charging a high discount rate, Bank X might simply turn John Smith’s loan application down. By raising its discount rate, the Fed would have reduced the amount of money created by Bank X.

Finally, the Fed influences the money supply by engaging in what are called open-market operations: the buying or selling of government securities, such as treasury bills, treasury notes, and treasury bonds (different investment opportunities offered by the government, on which the government pays interest, and whose value the government guarantees). When the Fed buys government securities, it essentially injects money into the banking system, because it is buying the securities from individual dealers who deposit the Fed’s checks in banks like Bank X. When the Fed sells government securities, it essentially takes money out of the banking system, because then individual dealers write checks that are payable to the Fed, and the money is withdrawn from the individuals’ accounts at their own banks. This decreases the deposit totals of banks like Bank X.

Recent Trends

Today the media commonly reports on Fed announcements regarding interest rates, but few people correctly understand these reports. To decipher them, it would be necessary to understand the different types of interest rates (the discount rate, the federal funds rate, and the prime interest rate) that most crucially affect the economy and to understand the Fed’s relationship to each.

The Fed is responsible for setting the discount rate, or the rate it charges on loans that it makes to banks who want to borrow money. While this rate can affect the money supply, it is not usually the most influential interest rate in the bigger economic picture. When banks want to increase their reserves, they usually borrow from one another rather than from the Fed.

The rate that banks charge one another for loans is called the federal funds rate. While the Fed does not directly set the federal funds rate, it makes announcements publicizing what it thinks that rate should be; then it can enforce that target rate by using open-market operations to change the money supply. If the Fed decreases the money supply by selling government securities, interest rates tend to rise. If the Fed increases the money supply by buying government securities, interest rates tend to fall. Because banks commonly borrow money from one another to cover shortfalls in their reserves, the federal funds rate has a direct effect on the rates that banks charge consumers and businesses who take out loans.

The rate that individual banks charge consumers and businesses is based on what is called the prime interest rate. The prime rate is the standard interest rate set by major banks. It serves as a baseline to which individual banks add percentage points (raising the interest rate slightly), depending on the circumstances surrounding individual loans. Adding percentage points ensures that the bank covers its costs and makes a profit. In principle the prime rate depends on market forces such as supply and demand; in practice, however, it is closely tied to the federal funds rate. Today the prime interest rate is generally about 3 percentage points higher than the federal funds rate.

Therefore, while TV newscasters are not technically accurate when they say, for example, “The Fed lowered interest rates today,” practically speaking the Fed does have the power to change all of the economy’s key interest rates.