Federal Reserve

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File:Federal Reserve.jpg
The Federal Reserve System is headquartered in the Eccles Building on Constitution Avenue in Washington, DC.

The Federal Reserve System (also the Federal Reserve; informally The Fed) is the central banking system of the United States.

The Federal Reserve System is composed of a central Board of Governors in Washington, D.C. and twelve regional Federal Reserve Banks located in major cities throughout the nation. Alan Greenspan currently serves as the Chairman of the Board of Governors of the Federal Reserve. On October 24, 2005, President Bush nominated Ben Bernanke to replace Greenspan as Chairman. Greenspan will retire on January 31, 2006 after 18 years as Chairman.


Main article: History of Central Banking in the United States

The first institution with responsibilities of a central bank in the US was the First Bank of the United States, chartered in 1791. Later, in 1816, the Second Bank of the United States was chartered. From 1837 to 1862, in the Free Banking Era there was no formal central bank, while from 1862 to 1913, a system of (private) national banks were in charge. After a series of devastating bank runs, it was decided that the US needed a centralized banking system.

The Federal Reserve Board was created by the U.S. Congress through the passing of the Owen-Glass Act, signed by President Woodrow Wilson on December 23, 1913.

Roles and responsibilities

The main tasks of the Federal Reserve are:

Other tasks include:

  • Economic research
  • Economic education
  • Community outreach

== Organization of the Federal Reserve ==

File:Eccles Building south side.jpg
Federal Reserve headquarters, Eccles Building, Washington, DC.

The Federal Reserve is comprised of a board of governors. The 7 members of the board are appointed by the President and confirmed by the Senate. Members are elected to terms of 14 years, with the ability to serve for no more than one term. A governor may serve the remainder of another governor's term in addition to their own full term. The Federal Open Market Committee (FOMC) comprises the 7 members of the board of governors and 5 representatives selected from the Federal Reserve Banks. The representative from the 2nd District, New York, is a permanent member, while the rest of the banks rotate on two and three year intervals.

The current members of the Board of Governors are:

As of late 2005 there were two openings on the Board of Governors following the departures of Ben Bernanke and Edward Gramlich.

Interest rates

File:Federal Funds Rate (effective).png
The effective federal funds rate charted over fifty years

The Federal Reserve implements monetary policy largely by attempting to steer the federal funds rate, also called the overnight rate. This is the rate that banks charge each other for overnight loans of federal funds. The Federal Reserve Board affects the federal funds rate by using open market operations, which is the purchase and sale of Treasury securities. If it wants to inject money into the economy, then it buys bonds, which also lowers interest rates. If it wants to lower the money supply, it sells bonds, which raises interest rates.

The Federal Reserve can also directly set the discount rate, which is the interest rate that banks pay the Fed to borrow from it. However, banks tend to prefer to borrow from each other than directly from the Fed. The discount rate is often higher than the fed funds rate, and it can also attract heightened regulatory scrutiny of the borrowing bank.

Both of these rates influence the prime rate which is usually about 3 percentage points higher than the federal funds rate. The prime rate is the rate that most banks price their loans at for their best customers.

Lower interest rates stimulate economic activity by lowering the cost of borrowing, making it easier for consumers and businesses to buy and build. Higher interest rates slow the economy by increasing the cost of borrowing. (See monetary policy for a fuller explanation.) The IS/LM model was developed by John Maynard Keynes to explain how the demand for money, investment activity, and interest rates are connected.

The Federal Reserve usually adjusts the federal funds rate by 0.25 or 0.50 percentage points at a time. From early 2001 to mid 2003 the Federal Reserve lowered its interest rates 13 times, from 6.25 to 1.00 percent, to fight recession. In November 2002, rates were cut to 1.75, and many interest rates went below the inflation rate. (This is known as a negative interest rate, because money paid back from a loan with an interest rate less than inflation is worth less than its original value.) On June 25, 2003, the federal funds rate was lowered to 1.00 percent, its lowest nominal rate since July, 1958, when the overnight rate averaged 0.68 percent. Starting at the end of June, 2004, the Federal Reserve started to raise the target interest rate in response to concerns about the potential for increased inflation from a too-active economy. As of November 2005, the rate is at 4.00 percent; this is the result of eleven 0.25 percent increases.

The Federal Reserve has limited impact on longer-term interest rates. It can also attempt to use open market operations to change long-term interest rates, but its "buying power" on the market is significantly smaller than private institutions. The Fed can also attempt to "jawbone" the markets into moving towards the Fed's desired rates, but this is not always effective.

The Reserve Banks

File:US fed res regions.gif
Federal Reserve Regions

The twelve regional Federal Reserve Banks, which were established by the Congress as the operating arms of the nation's central banking system, are organized much like private corporations—possibly leading to some confusion about “ownership.” For example, the Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company. The Reserve Banks are not operated for profit, and ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold or traded or pledged as security for a loan; dividends are, by law, limited to 6 percent per year.[1]

The dividends paid to member banks are considered partial compensation for the lack of interest paid on member banks' required reserves held at the Fed. By law, banks in the United States must maintain fractional reserves, most of which are kept on account at the Fed. The Federal Reserve does not pay interest on these funds.

The Federal Reserve System was created via the Federal Reserve Act of 1913 which "established a new central bank designed to add both flexibility and strength to the nation's financial system." The legislation provided for a system that included a number of regional Reserve Banks and a seven-member governing board. All national banks were required to join the system and other banks could join. The Reserve Banks opened for business in November 1914. Congress created Federal Reserve Notes to provide the nation with an elastic supply of currency. The notes were to be issued to Reserve Banks for subsequent transmittal to banking institutions in accordance with the needs of the public.

The Federal Reserve Districts are as follows:

  1. Boston [2]
  2. New York [3]
  3. Philadelphia [4]
  4. Cleveland [5]
  5. Richmond [6]
  6. Atlanta [7]
  7. Chicago [8]
  8. St Louis [9]
  9. Minneapolis [10]
  10. Kansas City [11]
  11. Dallas [12]
  12. San Francisco [13]

Legal Status and Position in Government

The Federal Reserve System is an independent government agency. It is subject to laws like the Freedom of Information Act and the Privacy Act which cover Federal agencies and not private entities. However, its decisions do not have to be ratified by the President or anyone else in the executive or legislative branches of government, it does not receive funding from Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms. Once a member of the Board of Governors is appointed by the president, he or she is almost as independent as a U.S. Supreme Court judge, although it is not a lifetime appointment.

In the 1982 case Lewis v. United States, the Ninth Circuit Federal Court of Appeals stated that the "Federal reserve banks are not federal instrumentalities for purposes of a Federal Torts Claims Act, but are independent, privately owned and locally controlled corporations." The opinion also stated that "the Reserve Banks have properly been held to be federal instrumentalities for some purposes."

Influence of Government

The Federal Reserve is financially independent because it runs a surplus, due in part to its ownership of government bonds. In fact, it returns billions of dollars to the government each year. However, the Fed is still subject to oversight by the Congress, which periodically reviews its activities and can alter its responsibilities by statute. To further communication with Congress, the Fed delivers a report to both houses semiannually. Its independence from the executive branch was strengthened by the 1951 Accord. In general, the Federal Reserve must work within the framework of the overall objectives of economic and financial policy established by the government.

Fractional-Reserve Banking

Main article: fractional-reserve banking

In its role of setting reserve requirements for the country's banking system, the Fed regulates what is known as fractional-reserve banking. This is the common practice by banks of retaining only a fraction of their deposits to satisfy demands for withdrawals, lending the remainder at interest to obtain income that can be used to pay interest to depositors and provide profits for the banks' owners. Some people also use the term to refer to fiat money, which is money that is not backed by a tangible asset such as gold.

Criticism of the Fed

Economists sometimes criticise the Fed's monetary policy, arguing that it has raised interest rates too quickly or slowly. Economist John B. Taylor formulated the Taylor rule to explain how the Fed should decide interest rates. Many economists agree that the Fed exacerbated the Great Depression by contracting the money supply.

Other criticism includes general criticism of central banking and fractional-reserve banking as well as criticism specific to the Fed. Austrian School economists criticize fractional-reserve banking in general. They argue that it leads to inflation and wealth redistribution. They also blame the Fed as one of the chief factors in the Depression, but place their emphasis on the Fed's expansionary monetary and creditiary policy during the 1920s, causing a misallocation of capital investment.

More controversial are theories that propound the idea that the Federal Reserve was designed to transfer wealth from the American "people" to banks or other powerful groups. They say that it does this through inflation and monetizing government debt.

Some critics argue that Congress does not have the constitutional authority to delegate to an independent agency its power "to coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures" (Article I, Section 8, Clause 5 of the Constitution). Other critics say that the Federal Reserve System controls money through inflation, high interest rates, and taxation through the Fed's ownership of Treasury bonds as its principal asset - bonds that are eventually paid for by U.S. citizens. Still others argue that the Fed supports large national banks over smaller regional banks.

Finally, some believe that the Federal Reserve is not neutral with regard to U.S. elections and tends to lower or raise interest rates to benefit or harm certain candidates. This criticism is particularly directed at current Chairman Alan Greenspan, who describes himself as a fan of Ayn Rand's economic individualism — the New York Times published a special article on his affinity for Rand's ideas and work — and worked for Republican politicians. The Fed raised interest rates before the presidential election of 2000 and lowered them before the 2004 election. However, it also lowered rates slightly before the 1996 election. Many Republicans blame Greenspan for an overly tight monetary policy before the 1992 election, hurting incumbent President George H.W. Bush.

Further reading

  • Griffin, Edward G. (1998). "The Creature from Jekyll Island:A second look at the Federal Reserve". American Media. ISBN 0912986212.
  • Greider, William (1987). Secrets of the Temple. Simon & Schuster. ISBN 0671675567; a book intended for lay readers explaining the structures, functions, and history of the Federal Reserve, focusing specifically on the tenure of Paul Volcker
  • Epstein, Lita & Martin, Preston (2003). The Complete Idiot's Guide to the Federal Reserve. Alpha Books. ISBN 0028643232.
  • Meyer, Lawrence H (2004). A Term at the Fed : An Insider's View. HarperBusiness. ISBN 0060542705; focuses on the period from 1996 to 2002, emphasizing Alan Greenspan's chairmanship during the Asian financial crisis, the stock market boom and the financial aftermath of the September 11 attacks
  • Rothbard, Murray N. (1994). The Case Against the Fed. Ludwig Von Mises Institute. ISBN 094546617X.


  • Andrews, Edmund L. (Nov. 5, 2005). "All for a more open Fed". New Straits Times, p. 21.

See also

External links





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