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What Was The Reasoning Behind The Creation Of The Federal Reserve

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 8 minute read

Economics is a very difficult field of study because it seeks to explain the complex financial relationships between people, organizations, and governments. It is in the interest of governments to maintain healthy economies and high employment rates. 

But stock market collapses, bank failures and economic recessions can occur without competent management. As the United States central bank, the Federal Reserve or “Fed” is a household name. Its functions overlap with those of other government agencies, such as setting monetary policy, administering the national economy, and providing financial services to the US government.

Decisions made by the Fed can affect people and economies around the world. In this article, you’ll find out what the Federal Reserve is and how its actions affect you.

How Does the Federal Reserve System Work?

In the United States, the Federal Reserve System acts as the country’s primary banking infrastructure. The board of governors sits atop a complex structure that also includes twelve regional Federal Reserve Banks across the United States.

After a series of financial panics, Congress passed the Federal Reserve Act in 1913, giving the newly formed Federal Reserve the responsibility of long-term economic management in the United States with the goals of full employment, price stability, and moderate interest rates.

The Operation of the Federal Reserve System

There are four distinct parts that make up the Federal Reserve System. Various tasks are performed by each successive layer.

Board of Governors

The Board of Governors of the Federal Reserve System is a government entity responsible for monitoring the activities of the 12 regional Federal Reserve Banks. The seven-person Board of Governors also guides the nation’s monetary policy, notably through the establishment of target interest rates.

The President appoints the Governors, and the Senate must approve their appointments, for fourteen-year terms.

Banks of the Federal Reserve

Each of the 12 Federal Reserve Banks in the United States is in charge of one of the country’s 12 Federal Reserve Bank Districts. The Federal Reserve Bank in Boston, for instance, oversees New England, whereas the Federal Reserve Bank in New York is responsible for the administration of the state of New York. 

Each Federal Reserve district’s size is determined by the district’s population as of the Federal Reserve Act’s passage. Multiple functions are performed by Federal Reserve Banks. 

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

Committee for the Federal Open Market (FOMC)

A total of 12 people, including all seven Federal Reserve Governors and all five presidents of Federal Reserve Banks, make up the Federal Open Market Commission. The Federal Open Market Committee (FOMC) is the primary body in charge of the nation’s monetary policy, which it establishes through open market operations.

The target federal funds rate for overnight lending and the purchase and sale of securities on the open market are two important open market operations. The Federal Open Market Committee (FOMC) uses several methods to affect national interest rates and inflation.

Advisory Councils

The Federal Reserve Banks nominate 12 people to serve on the Federal Advisory Council (FAC). Representatives from the banking sector advise the Federal Reserve on issues relevant to the sector.

The FAC convenes at least quarterly. Members of the Council are appointed to staggered three-year terms.

The Federal Reserve System’s Purposes

The five key roles of the Federal Reserve in the economic management of the United States. Setting national monetary policy and ensuring economic stability are two examples of overlapping functions.

1. Formulating the Monetary Policy of the Country

U.S. monetary policy is decided upon by the Federal Open Market Committee (FOMC). As a rule of thumb, this entails concentrating on three separate aims.

  • Maximum employment
  • Stable prices
  • Moderate long-term interest rates

The Federal Open Market Committee (FOMC) reaches these objectives through open market operations, changes to the discount rate on loans from regional Federal Reserve Banks, and changes to the reserve requirement ratios that banks must maintain to offset loan losses.

The FOMC may try to reduce the money supply in response to excessive inflation by, say, selling government securities to financial institutions or by increasing the federal funds rate, both of which make borrowing money more expensive for consumers and businesses.

2. Supporting Economic Stability

In addition, the Federal Reserve seeks to maintain economic stability by working to prevent the economy from experiencing a constant cycle of boom and bust. The goal is to reduce the severity of economic downturns and avoid panic in the stock market.

The Fed keeps tabs on the US financial sector to look for systemic risks and other problems so it can address them and keep the economy stable. It keeps an eye on the international financial system for signs of trouble that could affect the US economy.

The Federal Reserve may try to avert a surge in inflation in the United States, for instance, if it sees inflation growing in other countries.

3. Controlling Banks

Private and commercial banks in the United States are governed by the Federal Reserve. Regulations governing the activities of banks are established by the Federal Reserve Board of Governors, usually in reaction to federal legislation.

Federal Reserve Regulation II, for instance, specifies the parameters and requirements for debit card interchange fees.

4. Defense of Customer Credit Rights

Customers frequently deal with banks and other lenders, so it’s crucial that they’re handled fairly. When it comes to credit, the Federal Reserve is in charge of ensuring consumers are treated fairly.

For instance, the Equal Opportunity Credit Act is enforced by Federal Reserve Regulation B, which forbids lenders from rejecting borrowers on the basis of their race, religion, national origin, sex, marital status, or other protected characteristics.

5. Giving the American Government Financial Services

The federal government, like everyone else, needs access to a bank account. Through its twelve regional banks, the Federal Reserve provides banking services to the various federal agencies and departments in the United States.

These financial institutions host U.S. Treasury accounts. The Federal Reserve banks aid the government by handling monetary transactions like tax deposits, federal tax refund cheques, money orders, and savings bonds.

The Federal Reserve’s Regulatory History

The Federal Reserve has been around for quite some time, and its function in overseeing the financial sector has evolved over the years. These are only a few of the most significant events in the Fed’s history, which spans over a century.

  • The law established the Federal Reserve System. The Fed was established in 1913 by the Federal Reserve Act, which was signed into law by President Woodrow Wilson. The Act was passed as a reaction to financial panics like the one in 1907, which saw stock prices plummet by 50 percent in three weeks and led to numerous bank runs.
  • The Great War, or World War I. During the war, the Fed provided emergency currency to help keep banks working properly. Facilitated the transport of products to Europe. As confidence in the gold standard waned after the war, open market activities were instituted.
  • The Crash of ’29 and the ensuing Great Depression. The Federal Reserve did not react quickly enough to market speculation that led up to the 1929 catastrophe. Glass-Steagall was passed in 1933 and mandated Federal Reserve supervision of bank holding firms as well as the creation of the FDIC.
  • This is known as the Treasury Accord. In 1951, the Fed was given additional leeway in determining monetary policy and interest rates when the Treasury and the Fed agreed to split these duties under The Treasury Accord.
  • It’s called the Act for Monetary Control. This act from 1980 mandated reserve requirements and set prices for the Fed’s services at a level competitive with the private sector. Cross-border banking was given a boost as a result of this.
  • The ’90s Economic Boom. The Fed pledged “its willingness to serve as a source of liquidity to assist the economic and financial system” after the 1987 stock market crisis. It was the beginning of a decade of economic growth.
  • The Terrorist Attack on September 11th. After 9/11 shook up the financial markets, the Fed once again declared its willingness to respond by lending more than $45 billion to restore order in the economy and head off a financial meltdown.
  • The legislation is known as the Gramm-Leach-Bliley Act. Some restrictions on banks, investment firms, and insurance providers had been lifted by the Federal Reserve as a result of the Gramm-Leach-Bliley Act. It also mandated that financial institutions safeguard customer data.
  • Amending the Constitution to remove the Glass-Steagall Act. In 1999, Congress did away with the Glass-Steagall Act, which had previously kept investment and commercial banking separate. The Federal Reserve’s interpretations of the Act in the 1980s and 1990s undermined many of the limits it imposed, which contributed to its eventual repeal.
  • Specifically, the Great Recession. The Federal Reserve’s response to the Great Depression was to increase the money supply, in the hopes of easing its effects. By, for instance, purchasing billions of dollars worth of assets every month, significantly increased the money supply.
  • In other words, the Dodd-Frank Act. This law, passed in reaction to the Great Recession, significantly altered the rules governing the American financial sector. It mandated a review of the Federal Reserve’s operations, established a new function for the oversight and regulation of the financial industry, and granted the Fed expanded authority to impose regulations on financial institutions.
  • This epidemic is caused by the COVID-19 virus. In order to keep the economy going and lessen the fiscal impact of the COVID-19 pandemic, the Fed helped increase the money supply.
  • Increased prices after a pandemic. Inflation in the United States picked up as the COVID-19 epidemic wound down. The Federal Open Market Committee (FOMC) responded by increasing the federal funds rate to curb spending by consumers and businesses.

How You Are Affected by the Federal Reserve

When it comes to the nation’s economy, the Federal Reserve is the one to call. The Federal Open Market Committee and the Board of Governors of the Federal Reserve System aren’t just a bunch of bean counters. Their choices can have far-reaching effects on the national and global economies and on your daily life.

The FOMC, for instance, sets the federal funds rate as part of its open market activities. To meet reserve requirements, banks overnight lend to one other and earn interest at this benchmark rate.

Rates for nearly all loans are affected by this index rate. When the federal funds rate rises, the cost of loans and credit cards goes up for both consumers and businesses.

The Federal Reserve’s goal in formulating policy is to keep the employment rate as high as possible. The unemployment rate should be low if the Federal Reserve is doing its job. You should find it less challenging to secure employment and more lucrative opportunities as a result.

Bottom Line

There is no U.S. government or national or international financial system without the Federal Reserve System. Its actions and laws may have far-reaching consequences that affect your daily life.

You can be better prepared for whatever the future holds financially if you know how the Federal Reserve responds to economic situations and how that response can affect things like mortgage rates and the stock market.

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