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Originally Published: 3/15/2006


By The Issue Wonk



The Federal Reserve System, commonly known as the “Fed,” is the central bank of the United States.  It was founded in 1913 for the primary purpose of providing the nation with a flexible and stable monetary and financial system.  It’s role in the economy has since expanded and today its duties include:  (1) conducting the nation’s monetary policy by influencing money and credit conditions with a goal of full employment and little or no inflation; (2) supervising and regulating banking institutions to ensure they are sound and to protect the credit rights of consumers; (3) maintaining the stability of the financial system and reducing any risk that may arise in financial markets; and (4) providing financial services to the U.S. government, the public, and financial institutions, including operating the nation’s payment system.  Because the Fed is an independent central bank, its decisions do not have to be ratified by the president.  However, the entire system is subject to oversight by Congress because the Constitution grants Congress the power to coin money and set its value.


The Federal Reserve System is made up of the Board of Governors (known as the Federal Reserve Board) and 12 regional Federal Reserve Banks located in major cities across the United States.  The Board is responsible for forming and implementing monetary policy and shares responsibility with the Federal Reserve Banks for:  (1) supervising and regulating financial institutions; (2) providing banking services to depository institutions and the federal government; and (3) ensuring that consumers receive adequate information and fair treatment in their dealings with the banking system.


The Board of Governors is comprised of seven (7) members appointed by the president and confirmed by the Senate.  The full term of a board member is 14 years and the appointments are staggered so that one (1) term expires on January 31st of each even-numbered year.  After serving a full term, a board member may not be reappointed.  The chair and the vice-chair of the Board are named by the president from among the board members.  They are confirmed by the Senate and serve a term of four (4) years.  A member’s term on the Board is not affected by his or her status as chair or vice chair.


The Fed uses three (3) tools to conduct monetary policy:


Open Market Operations.  In order to increase the supply of money, the Fed buys government (mainly Treasury) securities in the open market (from banks, businesses, or individuals) with a check that is a new source of money that it prints.  That money is deposited in banks where they create new reserves.  The banks can then lend or invest that money, thereby increasing the amount of money in circulation.  On the other hand, if the Fed wishes to reduce the money supply, it sells government securities to banks, collecting the reserves from them and thus taking that money out of circulation.


Controlling the Money Supply.  The Fed can control the money supply by specifying what reserves the banks must set aside either as currency in their vaults or as deposits at their regional Reserve Banks.  Raising the required reserves forces the banks to take money out of circulation.  Conversely, lowering the required reserves puts more money in circulation.  Also, since banks often lend each other money overnight, the rate on these loans, known as the “federal funds rate,” is a key gauge of how “tight” or “loose” monetary policy is at a given moment.


The Discount Rate.  This is the interest rate that commercial banks pay to borrow funds from the Fed.  By raising or lowering the discount rate the Fed can promote or discourage borrowing and thus alter the amount of revenue available to banks for making loans.


The Fed gets its money primarily from the interest in the U.S. government securities that it has acquired through the open market.  Other sources of income include:  (1) the interest on foreign currency investments that it holds, (2) interest in loans to depository institutions, and (3) fees received for services provided to depository institutions, such as check clearing, fund transfers, and automatic clearinghouse operations.  After it pays its expenses, the Fed turns the rest of its earnings over to the U.S. Treasury.




© The Issue Wonk, 2006




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