Lesson 9-3The Federal Reserve System

Backgound on the Federal Reserve System The Fed is the country’s central bank, which means the following: It acts as a banker to the central governmentIt acts as a banker to banks.It acts as a regulator of banks.It sets monetary policy.

The Federal Reserve System was not established until 1913. Americans were suspicious of a central bank for over 100 years. Bank panics caused people to lose their confidence in the banking system.The Panic of 1907 finally led to the passage of the Fed.

Structure of the Fed The Fed structure is the result of compromise on contradictory goals: (1) make the Fed as independent as possible; (2) make the Fed as decentralized as possible. Decentralization comes in several ways. There are 12 regional Federal Reserve Banks. Each bank is owned by member banks. The owner banks select the board of directors which selects the bank’s president. 

Independence is preserved in several ways. The Board of Governors, the board of the entire Federal Reserve System, is appointed by the President and confirmed by the Senate. Their independence is preserved by 14-year terms.

The Fed is authorized to buy and sell federal government bonds and is thus not dependent on Congress for income. The Fed is technically a private institution and not legally answerable to Congress, the President, or any other government official.

Powers of the Fed Reserve Requirements The Fed sets reserve requirements and could alter them as it wished. It does not do this often because of the instability such actions would create in the banking system. The Monetary Control Act of 1980 required virtually all banks, even nonmembers, to comply with reserve requirements set by the Fed.

The Discount Window The discount rate is the interest rate charge by the Fed when it lends reserves to banks. The Board of Governors sets the discount rate. Lowering the discount rate makes borrowing cheaper and could lead to an expansion of loans. Banks tend to borrow from the Fed only once or twice a year. 

Instead of Fed borrowings, banks tend to use the federal funds market to obtain reserves. The federal funds market is a market in which banks lend reserves to one another. The federal funds rate is the interest rate charged for reserves in the federal funds market.

Open Market Operations The Fed’s ability to buy and sell bonds is its most important monetary policy tool. A bond is a written promise by the issuer of the bond (in this case the federal government) to pay the owner of the bond a series of payments on specific dates. Open market operations are the buying and selling of federal government bonds by the Fed. Buying bonds by the Fed expands bank reserves. Selling bonds by the Fed reduces bank reserves. 

Open market operations can be illustrated by balance sheets. The Fed’s purchase or sale of bonds is conducted by the Open Market Desk at the Federal Reserve Bank of New York. Open market policies are set by the Federal Open Market Committee (FOMC). There are 12 members of the FOMC. All seven Board of Governors members serve. The President of the Federal Reserve Bank of New York serves.  

Other regional federal bank presidents rotate through the four other seats. The FOMC meets eight times per year and provides a report of its decisions immediately after each meeting.