Federal Reserve System

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Definition: Federal Reserve System



Full Definition of Federal Reserve System


The Fed, also known as the Federal Reserve System is the central bank of the US. The Federal Reserve Act was signed on December 23, 1913, by US President Wilson. The Chairman is Ben Bernanke. The Federal Reserve System is comprised of twelve Federal Reserve Banks. Each of these banks represents its own district. They are all overseen by the Board of Governors of the Federal Reserve System.

According to the Fed’s website, “The Federal Reserve System is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded.”

The Federal Reserve is subject to oversight by Congress but is an independent central bank which means its actions do not have to be ratified by the president. It is often described as “independent within the government”.

Contrary to popular belief, the Fed does not simply change interest rates at will. It sets target rates and attempts to move the market towards those rates by the sale or purchase of public debt (bonds).

Lower interest rates result in banks having easier access to money (cheaper) and therefore increase liquidity in the economy. Higher interest rates reduce funds in the economy.

In regulating output and price level (employment and inflation), the Fed must move the aggregate supply and aggregate demand curves to meet those goals.

In the United States, the Federal Reserve System was established in 1913 by the Federal Reserve Act. The primary basis for conceiving the Federal Reserve System was the mounting need to effectively regulate the U.S. monetary and banking system. The Federal Reserve System comprises twelve regional Federal Reserve Banks, as well as their twenty-four sub-branches. The headquarters of the Federal Reserve System is located in Washington D.C. National and state banks are also part of the Federal Reserve System. Today, the Federal Reserve System is at the core of the nation’s monetary and regulatory activity. The Federal Reserve System regulates the money supply, sets reserve requirements for member banks, and supervises the printing of currency at the mint. In addition to acting as a clearinghouse to transfer funds through the banking structure, the Federal Reserve System also provides many financial and research services to the U.S. government.

Objectives

  • Seeks to manage price levels (prevent excessive inflation or deflation).
  • Seeks to keep unemployment low, but this is somewhat contradictory to the first point.

Means to control the money supply

The Fed controls the nominal money supply through:

Reserve requirements of banks.
The discount window.
FOMC (federal open market committee)

Reserve requirements of banks

This is the amount of backup funds a bank must keep at the central bank. It is usually at about 11-12% but some responsible banks keep a bit more for security.

Discount window

This is the borrowing window for inter-bank overnight loans for banks only.

FOMC

The Federal Open Market Committee (FOMC) is what the Fed is most known for, as this group sets the monetary targets and oversees open market operations.

It is comprised of the following:

  • The president of the New York Federal Reserve Bank
  • The presidents of four other regional banks (on a rotating basis)
  • The Board of Governors of the Federal Reserve System

Pitfalls

The Fed plays a very delicate game and is subject to many pitfalls. The Fed can easily make mistakes. Following are some of the hazards it faces:

Crowding out occurs when the government seeks to induce growth via monetary expansion policies. In such an event, excessive federal spending can compete with private investment, resulting in a reduction of aggregate demand.

Inflation or a sustained increase in price levels (not a one-time increase) can result from the Fed’s actions. Increased money supply can create inflation. If the Treasury prints too much money, inflation will occur as well.

Deflation is the sustained drop in price levels. This is even more difficult to control than inflation because the Fed may lower interest rates to stimulate demand. However, once interest rates hit zero, as happened in Japan in the 90s, this open market tool of monetary policy is gone. Other things that can be done to revive the economy are to print money (very dangerous) or to give money to banks. Also, the Fed could rely on the supply side by cutting corporate taxes, reducing inefficient regulations, and increasing depreciation allowances.


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Definition Sources


Definitions for Federal Reserve System are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 27th March, 2020 | 0 Views.