Federal Reserve System Essay, Research Paper

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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