The Federal Reserve Bank

The Federal Reserve Bank

Name of the Student

Name of the Institution

Introduction

The Federal Reserve Bank is a financial institution that acts as the central bank of the US. It is based on a government agency called Federal Reserve System. Also known as Fed, the bank’s general role is to foster economic stability and sound banking system. The bank has branches in twelve districts established under the Federal Reserve Act. All branches of the bank work together to implement monetary policies formulated by the Federal Open Market Committee (FOMC) (Bordo & Roberds, 2013). This paper presents an overview of the Federal Reserve Bank. In particular, the paper examines the history, purpose and structure of the bank. In addition, the paper examines the tools that the bank uses to carry out its functions and how it uses these tools to implement monetary policy.

History

The Federal Reserve Bank has a long history that can be traced back in the 18th century. In 1970, Alexander Hamilton, the then Secretary of Treasury created a bill that proposed for the establishment of a central bank that would enhance economic stability and growth in the US after independence (Thomas, 2005). The efforts led to the establishment of the first central bank called the First Bank of the United States in 1971. The bank’s headquarter was in Philadelphia but it had branches in other major cities in the US. President George Washington signed a charter for the bank that would last for twenty years. After the expiry of the charter twenty years later, the US stayed for several years without a central bank. As a result, the US was hit by unusual inflation during the period. In response, James Madison signed another charter in 1816 and hence, the bank came back into existence (Thomas, 2005).

Even before the expiry of the charter, government funds were removed from the bank by President Jackson in 1833, during the Bank War era. Consequently, the US stayed without a central bank until 1913 when a Federal Reserve System was established. The efforts that led to the establishment of the Federal Reserve System were triggered by widespread calls for the government to establish a system that would act as the “lender of last resort” to troubled banks in times of crises, just as a certain private conglomerate was doing during the Panic of 1907 (Meltzer, 2010). The final draft of the Federal Reserve Act that led to the establishment of the Federal Reserve System was approved by the congress in December 1913, and it allowed for the creation of regional Federal Reserve Banks that would be operating under one supervisory board. To facilitate this, the Act allowed for the establishment of a committee that would divide the US into districts, each with eight to twelve cities. The Act stipulated that each district would contain one regional Federal Reserve Bank (Meltzer, 2010).

After successful establishment, the Federal Reserve System started operating in 1914. The Federal Reserve Act made it mandatory for all national banks to join the system. All other banks were free to join. The role of Fed has expanded since then from simply supporting banks during periods of crises to being a supervisor and regulator of the US banking system and a rescuer of banks that need additional credit any time in order to maintain stability (Bordo & Roberds, 2013).

Purpose

As mentioned earlier, the principle purpose of the Fed is to enhance economic stability and healthy banking system. The Fed has four key specific roles. Firstly, it provides financial services and support to banks in the US. For instance, it provides credit to banks that are at risk of facing financial instability. As well, it acts as the custodian of part of the financial assets of the bank. It also facilitates the transfer of funds from one bank to another. In doing so, the Fed ensures efficiency and safety of the payment system of the US. Secondly, the Fed acts as a bank for the US government. For instance, the US bank handles all revenues derived from taxes and payments made by the government. It provides financial services to the government through selling and redeeming of securities, including bonds, notes and treasury bills. It also issues and regulates the flow of paper and coin currency (Bordo & Roberds, 2013).

Another major role of the Fed is supervising and regulating activities of all banks operating in the US, including members of the system, foreign-owned banks and international banks. As well, Fed regulates the activities of US banks in foreign countries (Meltzer, 2010). The Fed ensures that banks operating in the US respect the credit rights of the consumers and adhere to the established credit regulations. In addition, the Fed regulates the purchase of securities through setting a limit on borrowings meant for that purpose. Lastly and most important, the role of Fed is to formulate and implement monetary policies (Bordo & Roberds, 2013). The Fed does this through taking actions that influence the amount of credit and money circulating in the economy of the US. In turn, changes in the amount of credit and money influence the interest rates and ultimately, the performance of the economy.

Structure

At the top of leadership of the Fed is Board of Governors, a government agency that is based in Washington. The board of governors is made up of seven members, a chairman and a vice chairman. All of them are appointed by the president and are approved after confirmation by the senate (Bordo & Roberds, 2013). Currently, there are twelve regional Federal Reserve Banks in different cities around the US and they operate under the Board of Governors (Bordo & Roberds, 2013). These banks carry out almost all work of the Fed. Each reserve bank generates its own income to support daily operations. The FOMC is the branch of Fed that makes policies. The FOMC is led by the chairman of the Fed’s Board. The voting members of the FOMC are the seven members of the board and a group of five rotating heads of the regional reserve banks. All heads of the Reserve Banks may engage in the discussions, whether they are voting or not. Lastly, the Federal Reserve banks regulate and supervise national banks and other banks that are members (Bordo & Roberds, 2013).

Tools

The Fed uses three main tools to implement monetary policy. The first tool is Open-Market Operations. Fed frequently sells and purchases government securities such as bonds and notes in the financial markets. In doing so, it regulates the amount of money reserves held in the US banking system. As well, these actions affect credit volume level, as well as interest rates paid by the consumers (Brezina, 2011). This is the tool that is most frequently used by the Fed to implement monetary policy. When the volume of level of money reserves in the banking system is too low to the extent that it leads to an increase in interest rates for credit, the Fed responds by purchasing government securities in an open market in order to increase money reserves (Brezina, 2011). The opposite applies when the level of money reserves held in the banking system is too high. The second tool used by Fed is Discount Rate. The Discount Rate is the interest charged by the Reserve Banks on short-term loans taken by banks. When the Reserve Banks lower the Discount Rate, the banks are encouraged to borrow more and to lower the interest rate paid by consumers on credit. This leads to an increase in the level of monetary reserves and credit. The opposite happens when the Federal Reserves raise the Discount rate (Brezina, 2011).

The third tool that is used by the Fed is Setting Reserve Requirements. Reserve requirement refers to the level of the physical funds that banks are required by the Fed to hold in bank accounts against the amount they hold in reserves. In other words, it refers to the amount physical funds that banks are required to hold, rather than lent out. The Reserve Requirement in the US is usually around 10 percent. When the Fed notices that the amount of money in circulation is too high to the extent that it leads to an increase in inflation rate, the Fed may respond by raising Reserve Requirement in order to reduce the amount of money lent out to the consumers (Board of Governors of the Reserve Federal System, 2014).

Conclusion

In conclusion, the Fed is the key financial institution that plays the role of regulating and supervising the baking system and economic stability in the US. The origin of the institution can be traced back in the 18th century. It is based on the structure of the federal system, an independent agency that is headed by Board of Governors. The Fed uses three main tools to implement monetary policy, namely, Open-Market Operations, Reserve Requirements and Discount Rate.

References

Board of Governors of the Reserve Federal System (2014). Monetary Policy, Retrieved from

HYPERLINK “http://www.federalreserve.gov/monetarypolicy/default.htm” http://www.federalreserve.gov/monetarypolicy/default.htm

Bordo, M. D. & Roberds, W. (2013). The Origins, History, and Future of the Federal Reserve: A

Return to Jekyll Island. Cambridge University Press

Brezina, C. (2011). Understanding the Federal Reserve and Monetary Policy. New York, NY:

The Rosen Publishing Group

Meltzer, A. H. (2010). A History of the Federal Reserve, Volume 1: 1913-1951, Volume 1.

Chicago: University of Chicago Press

Thomas, L. (2005). Money, Banking and Financial Markets. New York, NY: Cengage Learning