SSEMA2 The student will explain the role and functions of the Federal Reserve System.

a. Describe the organization of the Federal Reserve System.

The Federal Reserve System is the Unites States’ decentralized, central bank. It is both public and private in nature. It was created in 1913 to help instill trust in the country’s banking system. Since the Federal Reserve can act as the “lender of last resort” to help struggling banks meet their depositor’s demand for money, people are less likely to fear bank failure.

The following characteristics are the public aspects of America’s Federal Reserve System: 1. It was created by an act of Congress, so it can be dissolved by an act of Congress. In this way, the Federal Reserve is checked by those elected by the people.

Board of Governors 2. The seven members of the Board of Governors of the Federal Reserve System are nominated by the President and confirmed by the Senate. They are the public part of the Federal Open Market Committee that makes monetary policy decisions. A full term is fourteen years. One term begins every two years, on February 1 of even-numbered years. The Chairman and the Vice Chairman of the Board are named by the President from among the members and are confirmed by the Senate. They serve a term of four years.

Board of Governors 3. The Federal Reserve is the fiscal agent for the United States government. 4. The United States paper currency is called a Federal Reserve Note because it is backed by the assets of the Federal Reserve mainly the government securities (bonds) it holds. 5. Profits earned by the Federal Reserve System are transferred to the United States government. In 2011, the Federal Reserve transferred over $79 billion in profits to the U.S. Treasury.

The following characteristics are the private aspects of America’s Federal Reserve System: 1. The system is decentralized with 12 district banks serving the needs of different regions of the country. 2. The board of directors for each of the 12 district banks includes two-thirds of directors elected by the privately controlled member banks of that district as well as one third of the directors elected by the Board of Governors

3. There are five district bank presidents serving as voting members of the FOMC at any given time. The New York Federal Reserve Bank President is always a voting member of the FOMC and four other district Federal Reserve Presidents serve as voting members on a rotating basis. 4. Each district Federal Reserve Bank is organized as a private corporation and it self-financed through interest earned on securities held or payments for services like check-clearing.

b. Define monetary policy.

Monetary policy refers to the tools used by the Federal Open Market Committee to stabilize the economy. Since the Great Recession, the tools of monetary policy have expanded. However, the three main monetary policy tools with which students should be familiar are open market operations, changes in the discount rate, and changes in the reserve requirement. Open market operations refer to the buying and selling of government securities (bonds) on the open market.

The Discount Rate is the interest rate the Federal Reserve charges banks on money they borrow from the Federal Reserve The Reserve Requirement is the percentage of customer deposits banks cannot loan to borrowers. For example, if a bank has $10,000 in deposits and the reserve requirement is 10%, then the bank can only make loans up to $9,000. The other $1,000 must be held in vault cash or in the bank’s reserve account at the Federal Reserve.

c. Describe how the Federal Reserve uses the tools of monetary policy to promote price stability, full employment, and economic growth.

price stability If the Federal Reserve is concerned about price stability, it is usually worried that the inflation rate is increasing. This means the Federal Reserve needs to use monetary policy that will decrease the money supply.

Open Market Operations The most common tool used by the Federal Reserve is Open Market Operations. If the Federal Reserve wants to reduce the money supply to decrease the rate of inflation, it will sell bonds (securities). An open market sale of bonds means that banks and individuals will use their money to purchase the security. This money will no longer be in the banking system to be used for loans or spending. Since there is less money available for lending, the price banks charge each other for lending money (the Federal Funds Rate) rises, reducing borrowing activity.

Discount Rate The next most commonly used tool of monetary policy used by the Federal Reserve is the Discount Rate. When the Federal Reserve is concerned about inflation, it will raise the discount rate. Usually, changes in the discount rate are a signal to banks to raise the federal funds rate and borrow less from each other to make loans. This reduces spending and helps to bring price level (inflation) down

reserve requirement A change in the reserve requirement is the tool least often used by the Federal Reserve. Changes to this factor in the banking system can create very large changes in the money supply. T his occurs because changes in the reserve requirement have what economists call a large multiplier effect. However, if the Federal Reserve decided to change the reserve requirement to combat inflation, it would raise the reserve requirement, reducing the amount of deposits banks could lend.

promote full employment and economic growth Monetary policy can also be used to promote full employment and economic growth. Economists use the term full employment to describe the level of employment when all factors of production are being used efficiently. It is the same as an economy operating on its production possibilities curve. Full employment can also refer specifically to labor resources. At full employment, the unemployment rate is equal to the structural plus the frictional unemployment rates and there is no cyclical unemployment in the economy.

expansionary (or loose) monetary policy. If the Federal Reserve wants to promote full employment and economic growth, it will use expansionary (or loose) monetary policy. It will buy bonds (securities), causing the Federal Funds Rate to fall and encouraging more borrowing activity. In some cases, it will lower the discount rate as a signal to banks to increase lending. And, finally, in rare cases, it could lower the reserve requirement ratio, allowing banks to lend more of their deposits.