The Federal Reserve System
What is the Fed?
One of the more mysterious areas of the economy is the role of the Fed. Formally known as the Federal Reserve, the Fed is the gatekeeper of the U.S. economy. It is the central bank of the United States -- it is the bank of banks and the bank of the U.S. government. The Fed has several important jobs. The Fed regulates financial institutions, manages the nation's money, and influences the economy. By raising and lowering interest rates, creating money and using a few other tricks, the Fed can either stimulate or slow down the economy. This manipulation helps maintain low inflation, high employment rates, and manufacturing output.
One of the more mysterious areas of the economy is the role of the Fed. Formally known as the Federal Reserve, the Fed is the gatekeeper of the U.S. economy. It is the central bank of the United States -- it is the bank of banks and the bank of the U.S. government. The Fed has several important jobs. The Fed regulates financial institutions, manages the nation's money, and influences the economy. By raising and lowering interest rates, creating money and using a few other tricks, the Fed can either stimulate or slow down the economy. This manipulation helps maintain low inflation, high employment rates, and manufacturing output.
If you have headphones, watch this short video that puts the Fed in simple terms |
Why was it created?
Sometimes, in order to understand why you need something, it helps to find out what it was like before that "something" was created. Before the Federal Reserve was created in 1913, there were over 30,000 different currencies floating around in the United States. Currency could be issued by almost anyone -- even drug stores issued their own notes. There were many problems that stemmed from this, including the fact that some currencies were worth more than others. Some currencies were backed by silver or gold, and others by government bonds. There were even times when banks didn't have enough money to honor withdrawals by customers. Imagine going to the bank to withdraw money from your savings account and being told you couldn't because they didn't have your money! Before the Fed was created, banks were collapsing and the economy swung wildly from one extreme to the next. The faith Americans had in the banking system was not very strong. This is why the Fed was created.
The Fed's original job was to organize, standardize and stabilize the monetary system in the United States. It had to set up a method that could create "liquidity" in the money supply -- in other words, make sure banks could honor withdrawals for customers. It also needed to come up with a way to create an "elastic currency," meaning it had to control inflation by making sure prices didn't climb too quickly, and it needed a way of increasing or decreasing the country's supply of currency in order to prevent inflation and recession.
Sometimes, in order to understand why you need something, it helps to find out what it was like before that "something" was created. Before the Federal Reserve was created in 1913, there were over 30,000 different currencies floating around in the United States. Currency could be issued by almost anyone -- even drug stores issued their own notes. There were many problems that stemmed from this, including the fact that some currencies were worth more than others. Some currencies were backed by silver or gold, and others by government bonds. There were even times when banks didn't have enough money to honor withdrawals by customers. Imagine going to the bank to withdraw money from your savings account and being told you couldn't because they didn't have your money! Before the Fed was created, banks were collapsing and the economy swung wildly from one extreme to the next. The faith Americans had in the banking system was not very strong. This is why the Fed was created.
The Fed's original job was to organize, standardize and stabilize the monetary system in the United States. It had to set up a method that could create "liquidity" in the money supply -- in other words, make sure banks could honor withdrawals for customers. It also needed to come up with a way to create an "elastic currency," meaning it had to control inflation by making sure prices didn't climb too quickly, and it needed a way of increasing or decreasing the country's supply of currency in order to prevent inflation and recession.
Inflation
Inflation is not a good thing because it slows down economic growth. For example, when inflation is high, things cost more and people spend less. They also do less long-term planning that involves spending money, such as building houses and investing. Businesses are affected in the same ways. When inflation is high, it tends to fluctuate quite a bit. This uncertainty makes people wary of spending money for fear that inflation will increase even more and they won't be able to pay their bills High inflation also adds additional costs to long-term interest rates. These costs are to offset the risk associated with inflation. The additional costs make borrowing money less attractive. When people don't buy things (when demand is down), then the supply of goods gets too high, production has to decrease, and unemployment increases -- in other words, recession hits.
When prices are stable (when inflation is low), consumers make more purchases, investments, etc., production output is maintained and employment remains high. Recession When recession hits, the Fed can lower interest rates in order to encourage people to borrow money and make purchases. This works in the short run, but it has to be handled carefully so that inflation isn't impacted in the long run. The Fed has to carefully balance the short term goals of increasing output and employment with the long term goals of maintaining low inflation. |
GNP = Gross National Product
(the total amount of money made in a country) |
Fed Tasks
The Fed regulates financial institutions, acts as the U.S. government's bank, acts as a bank's bank, and is responsible for managing the nation's money. The Fed has two divisions: One group, the Board of Governors, is responsible for setting monetary policy and managing the nation's money; the other group, the 12 regional Reserve Banks, acts as the service division that carries out the policy and oversees financial institutions. The regional Reserve Banks represent the private sector. Both of these groups have the same goals.
In its role as money manager, the Fed has a primary goal to maintain stable prices (control inflation)
Click the link here to see if you can control inflation in our country as the chairman of the Fed.
The Fed regulates financial institutions, acts as the U.S. government's bank, acts as a bank's bank, and is responsible for managing the nation's money. The Fed has two divisions: One group, the Board of Governors, is responsible for setting monetary policy and managing the nation's money; the other group, the 12 regional Reserve Banks, acts as the service division that carries out the policy and oversees financial institutions. The regional Reserve Banks represent the private sector. Both of these groups have the same goals.
In its role as money manager, the Fed has a primary goal to maintain stable prices (control inflation)
Click the link here to see if you can control inflation in our country as the chairman of the Fed.
Fed Tasks: A Bank's Bank
Just as banks serve their customers, the Fed acts as a bank for banks. The Fed keeps the pipeline of transactions flowing. It processes and clears one-third of all the checks processed in the country -- that's about 20 billion checks per year. The regional Reserve Banks provide these services to the banks within their regions. The transactions are done on a fee basis, which is part of how the Federal Reserve supports itself. Banks are not required to use the Reserve Banks; they can choose to use a private competitor. This helps to ensure that the processing fees being charged are kept under control.
Just as banks serve their customers, the Fed acts as a bank for banks. The Fed keeps the pipeline of transactions flowing. It processes and clears one-third of all the checks processed in the country -- that's about 20 billion checks per year. The regional Reserve Banks provide these services to the banks within their regions. The transactions are done on a fee basis, which is part of how the Federal Reserve supports itself. Banks are not required to use the Reserve Banks; they can choose to use a private competitor. This helps to ensure that the processing fees being charged are kept under control.
Fed Tasks: The Government's Bank
The Fed maintains the checking account of the U.S. Treasury. As the largest bank customer in the country, the U.S. government does quite a bit of business and performs a lot of financial transactions, all of which are handled by the Fed. These transactions amount to trillions of dollars and include all of the tax deposits and withdrawals for U.S. citizens. It also includes securities such as savings bonds, Treasury bills, notes, and bonds that are bought by and for the U.S. government. Coin and paper currency produced by the U.S. Treasury's Bureau of the Mint and Bureau of Engraving and Printing is distributed to financial institutions by the Fed as part of its role as the government's bank. The Fed also monitors the condition of currency and either sends it back into circulation or has it destroyed. Because there are times during the year when people need more cash, currency is stored at Reserve Banks so that banks can order more paper money as they need it. These "orders" are paid for with funds from the bank's reserve account balance held with the Fed. |
The Fed Tool Box: The Discount Rate
The "discount rate" is the interest rate that a regional Reserve Bank charges banks and financial institutions when they borrow funds on a short-term basis. The Fed discourages banks from borrowing except for occasional, short-term emergency needs.
The discount rate often plays a larger role in the overall monetary policy than would be expected because it is a visible announcement of change in the Fed's monetary policy. Typically, higher discount rates indicate that more restrictive monetary policies are in store, while a lower rate might signal a less restrictive move.
Changes in the discount rate can affect:
· Lending rates (by making it either more or less expensive for banks to get money to lend or hold in reserve)
· Other open market interest rates in the economy (because of its "announcement effect")
Click here to see the regions of the Federal Reserve http://www.federalreserve.gov/otherfrb.htm
The "discount rate" is the interest rate that a regional Reserve Bank charges banks and financial institutions when they borrow funds on a short-term basis. The Fed discourages banks from borrowing except for occasional, short-term emergency needs.
The discount rate often plays a larger role in the overall monetary policy than would be expected because it is a visible announcement of change in the Fed's monetary policy. Typically, higher discount rates indicate that more restrictive monetary policies are in store, while a lower rate might signal a less restrictive move.
Changes in the discount rate can affect:
· Lending rates (by making it either more or less expensive for banks to get money to lend or hold in reserve)
· Other open market interest rates in the economy (because of its "announcement effect")
Click here to see the regions of the Federal Reserve http://www.federalreserve.gov/otherfrb.htm
Sources:
www.money.howstuffworks.com
www.federalreserve.gov
www.usmint.gov
www.money.howstuffworks.com
www.federalreserve.gov
www.usmint.gov
If you have time left, watch this overview video on why the Fed was created. https://www.youtube.com/watch?v=y1OJlJ9COg0
or try this game on the Federal budget http://www.icivics.org/games/peoples-pie
or try this game on the Federal budget http://www.icivics.org/games/peoples-pie