Federal Reserve System, central banking system of
the United States, popularly called the Fed. A central bank serves as the
banker to both the banking community and the government; it also issues the
national currency, conducts monetary policy, and plays a major role in the supervision
and regulation of banks and bank holding companies. In the United States these
functions are the responsibilities of key officials of the Federal Reserve
System, which is made up of a Board of Governors, located in Washington, D.C.,
and 12 district Federal Reserve banks, located throughout the nation. The Fed's
actions generally have a significant effect on U.S. interest rates and,
subsequently, on stock, bond, and other financial markets. See also United
States (Economy).
The Federal Reserve's basic powers are concentrated in
the Board of Governors, which is paramount in many policy issues concerning
bank regulation and supervision and in most aspects of monetary control. The
board announces the Fed's policies on both monetary and banking matters. Because
the board is not an operating agency, most of the day-to-day implementation of
policy decisions is left to the district Federal Reserve banks, stock in which
is owned by the commercial banks that are members of the Federal Reserve
System. Ownership in this instance, however, does not imply control; the Board
of Governors and the heads of the Reserve banks orient their policies to the
public interest rather than to the benefit of the private banking system.
The U.S. banking system's regulatory apparatus is
complex. The Federal Reserve shares authority in some instances—for example, in
approving bank mergers or in examining banks—with other federal agencies such
as the Office of the Comptroller of the Currency and the Federal Deposit
Insurance Corporation (FDIC). In the critical area of regulating the nation's
money supply and influencing interest rates in accordance with national
economic goals, however, the Federal Reserve is independent within the
government.
This independence is partially ensured by the fact
that the income and expenditures of the Federal Reserve banks and of the Board
of Governors are not subject to the congressional appropriation process; the
Federal Reserve is self-financing. Its income comes mainly from interest on
Reserve bank holdings of income-earning securities, primarily those of the U.S.
government. Outlays and other charges are mostly for operational expenses in
providing services to the government and for expenditures connected with
regulation and monetary policy.
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II
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HISTORY
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During the 50 years before the passage of the
Federal Reserve Act of 1913, surging economic growth was interrupted by
economic crises, frequently accompanied by the collapse of the monetary system.
The U.S. banking system was unable to respond flexibly to business cycles (see
Business Cycle).
Under the National Bank Act of 1864, the banking
system was divided into three groups: central reserve city banks (the first was
located in New York City; Chicago, Illinois, and St. Louis, Missouri, were added
in 1887), reserve city banks (in 16 other large cities), and country banks. All
national banks were required to hold cash reserves, but country banks could
hold a percentage of these deposits in reserve city banks. When country banks
required additional reserves to meet their customers' cash demands, they would
demand their reserves from reserve city banks, which would in turn demand funds
from central reserve city banks. If a reserve bank did not have enough cash to
meet the demand, the entire system would collapse, and the economy would not
have enough cash available to meet the economy’s needs. No mechanism was in
place to create additional cash, and a cash crisis would occur. Banking crises
such as these occurred in 1873, 1884, 1893, and 1907. The panic of 1907 led to
the formation in 1908 of a bipartisan congressional body, the National Monetary
Commission, whose report set the stage for the Federal Reserve Act of 1913 and
a decentralized, adaptable banking system and monetary authority that could avoid
these crises by providing the currency necessary to meet the economy’s needs.
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III
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STRUCTURE
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At the base of the Federal Reserve System
are the member commercial banks. All national, or federally chartered, banks
are required to join the system; membership of state-chartered institutions is
voluntary. Members have to purchase capital stock in their district Federal
Reserve bank in the amount of 6 percent of their capital, excluding retained
earnings, and get the right to vote for six of the nine directors of that
district bank. Stock ownership does not convey control or the financial
interest normally attached to stock in a corporation. The stock may not be sold
or used as collateral and must be returned to the district reserve bank if the
commercial bank ceases to be a member.
The Monetary Control Act of 1980 imposed a reserve
requirement on all depository institutions, including nonmembers of the Federal
Reserve, but it also permits them to borrow from the Federal Reserve and to use
services provided by the Fed, such as check clearing, electronic funds
transfer, and securities safekeeping. By enabling banks to borrow reserves from
the Fed, the liquidity of the entire banking system is increased.
The 12 district reserve banks are located in the
following cities: Boston, Massachusetts; New York City; Philadelphia,
Pennsylvania; Cleveland, Ohio; Richmond, Virginia; Atlanta, Georgia; Chicago;
St. Louis; Minneapolis, Minnesota; Kansas City, Missouri; Dallas, Texas; and
San Francisco, California. Each bank is formally responsible to a nine-member
board of directors, which is divided into three classes. Class A and B
directors are elected by the member banks; class C directors are appointed by
the Board of Governors. The board of directors is responsible for the
administration of its bank and for appointing the bank's president and vice
president (subject to the approval of the Board of Governors). The directors
also set the discount rate—that is, the interest rate charged to banks for
borrowing from the Reserve banks—again, subject to review by the Board of
Governors.
Reserve banks implement the decisions made by the Fed's
Board of Governors and by their own officers. Their staffs examine state member
banks (national banks are examined by the staff of the Office of the
Comptroller of the Currency; insured nonmember banks are subject to FDIC
examination), decide on granting loans to members, and carry out the routine
banking functions for the federal government. Decisions on whether to allow a
bank to open branches, to merge with another bank, or to form a holding
company (company that offers a broad range of financial services) are often
handled by reserve bank officers. Sales and purchases of securities for the
Federal Reserve System's own account are conducted by the Federal Reserve Bank
of New York, which is also the operating arm for international financial
activities.
At the top of the Federal Reserve System
is the Board of Governors, which over the years has undergone significant
change both in its responsibilities and its structure. The 1913 act established
a seven-member Federal Reserve Board, consisting of five presidential
appointees, each from a different Federal Reserve district, plus the secretary
of the treasury and the Comptroller of the Currency. Terms of office for the
appointees were initially set at ten years and were staggered, so that no two
would end at the same time; board members could not be removed from office
except for cause. These provisions were meant to help insulate the presidential
appointees from day-to-day politics. The board's powers, nevertheless, were
confined to supervising the reserve banks, with limited power over the discount
rate and little discretion over the structure of the banking industry.
The Banking Act of 1935, which also finalized
the creation of deposit insurance and the FDIC, centralized power in a Board of
Governors, and made all seven members presidential appointees with the advice
and consent of the U.S. Senate; the president also appoints a governor to serve
as Fed chairman for a four-year term. Alan Greenspan was the Fed chairman from
1987 until 2006, when he was replaced by Ben S. Bernanke. The governors' terms
were expanded to 14 years by the 1935 act, and their powers were also expanded.
For example, discount rates now had to be approved periodically by the board.
Sales and purchases of government securities—the open-market operation that
previously had been managed solely at the discretion of the presidents of the
reserve banks—were centralized in the Federal Open Market Committee (FOMC),
consisting of the seven governors, the president of the Federal Reserve Bank of
New York, and four other reserve bank presidents serving on a rotating basis.
Since 1935, Congress has given additional powers to the Board of Governors.
These powers include control over mergers, bank holding companies, U.S. offices
of international banks, and the reserves of all depository institutions.
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IV
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MONETARY CONTROL
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The Fed is best known to the public for the
influence it has on interest rates by “loosening” or “tightening” the money
supply. The term money supply has various technical definitions (see Money),
but basically it is the amount of currency, coin, and checking account balances
available at any one time in the U.S. financial system. The interest rate that
Fed policymakers focus on primarily is the federal funds rate, the interest
rate at which banks lend money to other banks that need to make loans.
The Federal Reserve's open market operations are the
most flexible and most frequently used instrument of controlling the money
supply and the federal funds rate. When the FOMC decides that the money supply
is growing too slowly to meet the economy’s needs or that interest rates are
too high, the Fed purchases U.S. Treasury securities on the open market—that
is, from the public and banks—thus injecting cash into the financial system and
expanding bank reserves and lowering the federal funds rate. This process enables
banks to loan more money, which helps businesses and consumers and helps the
economy grow faster. Conversely, should the money supply or economy grow more
rapidly than is desired or should interest rates be too low, which may lead to inflation
(a sustained increase in prices), the FOMC will sell securities of the
Department of the Treasury on the open market. Such sales reduce bank reserves
and raise the federal funds rate and thus slow down the economy. Generally,
this reduces the money supply and protects against inflation.
Although the open-market operation is the most flexible
and the most frequently used instrument of monetary policy, similar results can
be achieved by changing the required reserve ratio—that is, the percentage of
deposits that banks must maintain on reserve as cash deposits at the Federal
Reserve banks. When the required reserve ratio is raised, banks are unable to
create as much money as they previously were able to because a larger portion
of their assets must be held in reserve; the converse is true when the reserve
ratio is reduced.
Also among its general controls, the Federal
Reserve can make changes in the discount rate, the rate of interest at which
the Fed lends money to banks. By raising the discount rate, the Fed discourages
banks from borrowing money from the Fed. The Fed does this typically when it
wants to reduce the money supply and slow the economy. Conversely, to increase
the money supply and expand the economy, the Fed lowers the discount rate. A
discount rate change may, at times, reinforce open-market operations. It may
also, at times, have an “announcement effect,” signaling a change in the
Federal Reserve's underlying evaluation of economic conditions.
The Federal Reserve also has a narrow role in
regulating operations of the stock market. It may selectively lower or raise
the margin requirement, which is the percentage of a stock price that must be
provided in cash by someone who buys the stock on credit. The margin
requirement, a legacy of depression legislation, aims to curb market
speculation.
The Credit Control Act of 1969 authorized the U.S.
president to give additional controls to the Federal Reserve. In 1980 the act
was used as a means of controlling various types of consumer credit. The
Gramm-Leach-Bliley Act of 1999 gave the Fed regulatory authority over the new
financial services holding companies. These companies can offer banking, issue
securities (stocks and bonds) and insurance, and other financial services all
“under one roof.” The Glass-Steagall Act of 1933 had prohibited banks from
engaging in many of these activities, such as underwriting securities and
insurance, because they were deemed risky at the time.
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V
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EFFECTS OF FEDERAL RESERVE POLICIES
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Most economists today tend to believe that the policy
record of the Federal Reserve has had mixed results during the Fed’s history
and that occasionally Fed actions have increased rather than decreased economic
instability. Many economists would agree, for example, that the Federal Reserve
is partly to blame for the severity of the Great Depression of the 1930s
because the Fed allowed the money supply to shrink dramatically. On the other
hand, many economists believe that the record of price stability during the
late 1950s, 1960s, and 1990s was partly due to the Fed's effective monetary
policy. Even this successful anti-inflation policy, however, had its critics
who argued that the tight monetary policy raised interest rates to unusually
high levels. Criticism was muted when both inflation and interest rates
steadily dropped through the mid- and late 1980s and into the early 1990s. Most
economists recognize that some economic problems, such as the negative economic
impact of the oil shortage of the 1980s, are supply-related phenomena that the
Federal Reserve is powerless to resolve.
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VI
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RELATIONS WITH THE GOVERNMENT
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The Federal Reserve is sometimes considered a
fourth branch of the U.S. government because it is made up of a powerful group of
national policymakers freed from the usual restrictions of governmental checks
and balances. Indeed, the Board of Governors is formally independent of the
executive branch and protected by tenure well beyond that allotted to the U.S.
president. In practice, the president will typically listen carefully to the
Fed’s policy suggestions. The Fed and the president frequently share the same
economic agenda, but sometimes they have different agendas.
The relationship between the Federal Reserve and
Congress is more complex. On the one hand, because it was created by Congress,
the central bank is unmistakably a creature of Congress, being responsible to
it for its mandate and its continued existence. On the other hand, the
self-financing feature of the Federal Reserve prevents Congress from exercising
influence through its budgetary authority. Thus, the Federal Reserve is
relatively free from the partisan political pressures that operate in the
Congress, although the Fed must report frequently to Congress on the conduct of
monetary policy.
