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What Is the Federal Reserve System

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Economics is a highly complicated subject that tries to understand how individuals, businesses, and nations interact with each other financially. Governments want to keep their economies strong, and their citizens employed. But without proper management, stock market crashes, bank failures, and economic recessions can occur.

The Federal Reserve, commonly known as the Fed, is the central bank of the United States. It has several overlapping objectives, including regulating and managing the nation’s economy, providing banking services to the US government, and determining monetary policy. 

The decisions that the Fed makes can have wide ranging impacts on individuals and the global economy. Read on to learn why the Fed exists and what its actions mean for you.

What Is the Federal Reserve System?

The Federal Reserve System is the system that services as the central bank for the United States. It is a multi-layered system with the board of governors at the top and twelve federal reserve banks located in different regions of the United States 

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Congress enacted the Federal Reserve Act in 1913 after a series of financial panics, tasking the newly-formed Federal Reserve with managing the U.S. economy to maximize employment, stabilize prices, and moderate interest rates over the long term.

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How the Federal Reserve System Works

The Federal Reserve System is composed of four layers. Each layer serves a different function.

Board of Governors

The Fed’s Board of Governors is a federal agency that oversees the 12 Federal Reserve Banks located around the United States. The seven-member Board of Governors is also responsible for steering the nation’s monetary policy, primarily by setting target interest rates.

The Governors are appointed by the President for fourteen-year terms and subject to approval by the Senate.

Federal Reserve Banks

There are 12 Federal Reserve Banks located around the United States, each managing one of 12 districts. For example, the Federal Reserve Bank in Boston is responsible for managing New England while the Federal Reserve Bank of New York manages New York state. The size of each district is based on the population of that Federal Reserve district at the time the Federal Reserve Act passed.

Federal Reserve Banks fill multiple roles. They:

  • Offer a place for banks to deposit their reserves
  • Provide short-term loans to banks
  • Issue currency
  • Administer government bank accounts
  • Auction and buy back federal debt

Federal Open Market Committee (FOMC)

The Federal Open Market Commission is a 12-member body composed of the seven Governors of the Federal Reserve plus five presidents of Federal Reserve Banks. The FOMC is primarily responsible for the nation’s monetary policy, which it sets through open market operations.

Key open market operations include setting the target federal funds rate for overnight lending and buying or selling securities to increase or decrease the country’s money supply. These activities allow the FOMC to influence national interest rates and inflation. 

Advisory Councils

The Federal Advisory Council (FAC) is a 12-member body composed of appointees from each of the Federal Reserve Banks. Typically coming from the banking industry, these representatives advise the Federal Reserve on the needs of the banking industry.

The FAC typically meets four times annually. Each member serves on the council for a term of three years.

The Functions of the Federal Reserve System

The Federal Reserve has five primary functions in managing the United States economy. These functions may overlap with one another — for example, setting national monetary policy and maintaining economic stability are closely linked.

1. Establishing the Nation’s Monetary Policy

The Federal Reserve’s FOMC establishes the monetary policy of the United States. Generally, this means targeting three distinct goals.

The Federal Open Market Committee achieves these goals through open market operations, by adjusting the discount rate on loans from the regional Federal Reserve Banks, and by adjusting the amount banks must keep in reserve to cover loan losses.

For example, in times of high inflation, the FOMC may try to decrease the money supply by selling government securities to financial institutions or raising the federal funds rate to make borrowing more expensive for individuals and businesses.

2. Providing Economic Stability

The Federal Reserve also aims to stabilize the economy — encouraging a stable rate of economic growth rather than a cycle of booms and busts. The idea here is to prevent stock market panics and ease the impact of recessions.

To promote stability, the Fed monitors the US banking system to try to identify systemic risks and other issues. It also monitors the global financial system to see how it may impact the economy of the United States.

For example, if the Fed notices rising inflation across the globe, it may take steps to try to prevent inflation from spiking in the United States. 

3. Regulating Banks

The Federal Reserve regulates private and commercial banks across the United States. The Federal Reserve Board of Governors creates regulations, often in response to laws passed by the federal government, to determine how banks are permitted to operate.

For example, Federal Reserve Regulation II sets up the rules and standards for debit card interchange fees.

4. Protecting Consumer Credit Rights

Consumers interact with banks and lenders all the time, so it’s important that they’re treated fairly by lenders. The Fed is responsible for protecting the rights of consumers when it comes to credit.

For example, Federal Reserve Regulation B implements the Equal Opportunity Credit Act, which requires that creditors not discriminate against potential borrowers on the basis of race, religion, national origin, sex, marital status, or other prohibited factors.

5. Providing Financial Service to the U.S. Government

Everyone needs a bank account, including the federal government. The Federal Reserve serves as the bank for the many U.S. government agencies and departments through its twelve regional banks. 

The U.S. Treasury maintains accounts at these banks. The Federal Reserve banks assist the government by processing checks, money orders, and savings bonds as well as receiving federal tax deposits.

History of the Fed’s Regulatory Role

The Federal Reserve has a long history and its role in regulating the financial industry has changed over time. These are some of the highlights from more than 100 years of Fed activity.

  • The Federal Reserve Act. Signed by President Woodrow Wilson, the Federal Reserve Act of 1913 created the Fed. The Act was a response to financial panics like the Panic of 1907, which saw stocks drop 50% in three weeks and featured multiple bank runs.
  • World War I. The Fed helped keep banks operating normally through the war with emergency currency. It also helped the flow of goods to Europe. Open market operations began after the war as the gold standard weakened.
  • The Stock Market Crash & Great Depression. The Fed failed to adequately respond to market speculation preceding the 1929 market crash. In 1933, the Glass-Steagall Act established the FDIC and required Fed oversight of bank holding companies.
  • The Treasury Accord. In 1951 The Treasury Accord established the division of responsibility between the Treasury and Fed for monetary policy, giving the Fed more power to set policy and interest rates.
  • The Monetary Control Act. In 1980, this act required the Fed to price its services competitively with the private sector and established reserve requirements. This helped encourage the growth of banking across state lines.
  • Economic Expansion of the 1990s. After the stock market crash of 1987, the Fed affirmed “its readiness to serve as a source of liquidity to support the economic and financial system.” This preceded a 10-year economic expansion.
  • Sept. 11 Terrorist Attack. When 9/11 disrupted financial markets, the Fed again issued an announcement of its readiness to respond and loan more than $45 billion to stabilize the economy and prevent financial crisis.
  • Gramm-Leach-Bliley Act. Under the Gramm-Leach-Billey Act, the Federal Reserve removed some barriers to financial services companies providing banking, investing, and insurance services. It also required that banks protect consumer privacy.
  • Repeal of the Glass-Steagall Act. The Glass-Steagall Act separated commercial and investment banking but was repealed in 1999. Part of the reason for the repeal was that the Federal Reserve’s interpretations of the Act in the 1980s and 90s weakened many restrictions it put in place.
  • The Great Recession. The Federal Reserve responded to the Great Recession by trying to boost the monetary supply and reduce the impact of the downturn. For example, it greatly boosted the monetary supply by buying billions of dollars of securities each month.
  • The Dodd-Frank Act. As a response to the Great Recession, this act overhauled U.S. financial industry regulations. It included an audit of the Federal Reserve, created a new role for supervision and regulation of the financial industry, and gave the Fed additional powers to place restrictions and requirements on banks.
  • The COVID-19 Pandemic. When the COVID-19 pandemic shut down the nation and severely limited economic activity, the Fed helped expand the money supply to keep the economy moving and reduce the fiscal impact.
  • Post-Pandemic Inflation. As the COVID-19 pandemic waned, inflation in the United State began to rise. The FOMC responded by raising the federal funds rate to try to increase interest rates and reduce consumer and business spending.

How the Federal Reserve Affects You

The Federal Reserve is primarily responsible for national monetary policy. However, the board of governors of the Federal Reserve System and the FOMC aren’t just economists that move numbers around a spreadsheet for the government. The decisions that they make have massive impacts on the country and the world’s economic development and can affect your everyday life.

For example, one of the things that the FOMC does as it conducts open market operations is determine the federal funds rate. This is a benchmark interest rate that determines how much interest banks get for overnight lending to each other to meet reserve requirements.

This benchmark rate impacts the rates for almost every type of loan. Increasing the federal funds rate makes credit products like mortgages and credit cards more expensive for consumers and business users.

Another Federal Reserve policymaking objective is maintaining maximum employment. If the Fed is working properly, the unemployment rate should be relatively low. This should make it easier for you to get a job and increase your earnings.

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Federal Reserve System FAQs

There’s no question that the Federal Reserve System is complicated. However, its impact on the national and global economy can’t be understated. These are some of the most common questions nonexperts have about how it works and why it’s important.

Why Do We Need the Federal Reserve?  

The Federal Reserve is tasked with managing the economy and trying to prevent financial crises and recessions. Before the Federal Reserve existed, financial panics and bank runs were far more common in the United States. 

The Federal Reserve also protects consumers on a daily basis, imposing regulations on banks to ensure that they treat people fairly.

Bottom line: The Fed has prevented untold financial pain and suffering since its inception and will continue to do so in the future.

Who Runs the Federal Reserve?

The Federal Reserve is run by the Board of Governors and its bodies, such as the Federal Reserve Banks and Federal Open Market Committee. Many of these positions are appointed by the President and approved by Congress, making them ultimately responsible to U.S. voters.

Where Does the Federal Reserve Get Its Money? 

The Federal Reserve primarily gets the money it uses for open market operations from the securities it owns. For example, the Fed receives interest payments from the government bonds that it owns, then use that money to buy additional securities, increasing the money supply.

Does the Federal Reserve Print Money? 

The Fed does not print money. The Treasury Department is responsible for that. However, the Fed can increase the supply of money in the economy by buying securities from financial institutions.

How Does the Federal Reserve Set Interest Rates? 

The Federal Reserve impacts interest rates by setting the federal funds rate, the interest rate for overnight lending between banks.

It sets the federal funds rate by adjusting the interest rate on banks’ reserve balances and adjusting the money supply.

What Banks Are Members of the Federal Reserve System? 

There are 12 government-run Federal Reserve Banks located around the country. The cities that are home to Federal Reserve Banks are:

  • Boston
  • New York
  • Philadelphia
  • Cleveland
  • Richmond
  • Atlanta
  • Chicago
  • St. Louis
  • Minneapolis
  • Kansas City
  • Dallas
  • San Francisco

Whether privately held or publicly traded, for-profit national banks must be members of the Federal Reserve, meaning they keep their reserve deposits in their district’s Federal Reserve Bank.

There are also nonmember institutions, though they are still subject to Fed regulations. Many credit unions and commercial banks are not part of the Federal Reserve system, as are some state-chartered and state-run banks. For example, the government-owned Bank of North Dakota is a nonmember bank that does business exclusively in North Dakota.

Final Word

The Federal Reserve System is an essential component of the U.S. government as well as the national and global financial system. The decisions it makes and regulations it imposes can have wide-reaching effects that also impact your everyday life.

If you understand how the Fed reacts to economic conditions and how those reactions can affect things like mortgage rates or the stock market, you’ll be better prepared to make informed financial decisions — whatever the future brings.

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