This paper provides an overview of the Federal Reserve System, the central bank of the United States established by Congress in 1913. It examines the Fed's four core responsibilities, the structure and composition of the Board of Governors, and the three primary tools used to conduct monetary policy: open market operations, the discount rate, and reserve requirements. The paper also traces key historical developments — including the Banking Act of 1935 — that shaped the Fed's current authority, and concludes with a brief assessment of the Federal Statistical System's role in supporting monetary and fiscal decision-making.
The Federal Reserve serves as the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a secure and stable monetary and financial system.
Today the Federal Reserve holds responsibilities in four areas: (1) conducting the nation's monetary policy; (2) supervising and regulating banking institutions and protecting the credit rights of consumers; (3) maintaining the stability of the financial system; and (4) providing certain financial services to the U.S. government, the public, financial institutions, and foreign official institutions.
The Federal Reserve System is controlled by the Board of Governors of the Federal Reserve System, which formulates the initial margin requirements under Regulations T, U, and X. Margin loan increases and decreases in aggregate value, relative to market capitalization, affect margin requirements and thereby influence the prices of common stocks. Proponents of margin requirement policy argue that these regulations affect the level and volatility of stock prices by shaping investors' demand for stocks.
The Federal Reserve System has been the central bank of the United States since 1913. The purpose of a central bank is to control the supply of money and credit to the economy. The Board of Governors is the main policy-making body in this process.
The Board comprises seven members, two of whom are appointed as chairman and vice chairman. Each governor serves a fourteen-year term, while the chairman and vice chairman each serve four-year terms. The president is responsible for appointing all seven governors, subject to Senate confirmation, as well as appointing the chairman and vice chairman. The relatively long terms served by Federal Reserve governors — second only to the lifetime appointments of federal judges — are designed to protect members from political pressure and to support independent decision-making.
Regulating the nation's money supply requires the Federal Reserve to control the amount of reserve funds held by banks and the level and direction of short-term interest rates. The Federal Reserve influences whether banks and other financial institutions make loans, depending on the profit margin — that is, the difference between the interest rate paid to attract deposits or borrow funds and the interest rate charged to customers for credit. The greater the profit margin banks can earn on new loans, the more willing they are to extend credit. To influence the interest rates that banks pay on deposits and borrowings, the Fed exercises the authority granted by Congress to create money.
The Fed creates money in three primary ways. The first is through open market operations. The Fed buys U.S. government securities from financial institutions by crediting their balance sheets in exchange for those securities. When securities are purchased directly from banks, the banks immediately record new liquid reserves on their books. When financial institutions deposit the proceeds from selling securities, reserves in the banking system increase. When banks accumulate excess reserves, they may lend those funds to other banks overnight as a means of earning interest. The increased supply of reserves relative to demand in the money market causes the overnight interest rate — known as the federal funds rate — to fall. This decline in the cost of credit to banks increases the profitability of new loans to businesses and individuals, providing greater incentives for banks to expand credit throughout the economy.
Open market operations are the primary tool for controlling money and credit. All decisions regarding open market operations are made by the Federal Open Market Committee (FOMC), with the Board of Governors holding the majority of votes. The FOMC has twelve voting members: the seven members of the Board of Governors and five of the twelve presidents of the regional Federal Reserve Banks. Each voting member holds one vote, and only a simple majority is needed to change policy. FOMC meetings are held approximately every six weeks to determine the appropriate level of reserves in the banking system and the target for short-term interest rates.
The second monetary policy tool is the discount rate — the interest rate the Fed charges on loans made directly to banks. The Fed can encourage or discourage bank borrowing by raising or lowering this rate, thereby influencing the volume of loans extended to the public. The Board of Governors sets the discount rate by majority vote, taking into consideration recommendations from the directors of the twelve regional reserve banks.
Historically, the discount rate has served two purposes: supporting monetary policy and providing emergency liquidity to troubled banks. The Fed has wrestled with the tension between these two missions. To stimulate credit growth in the economy through discount rate lending, the Fed sets the discount rate below other prevailing short-term interest rates; otherwise, banks would have no incentive to borrow from the central bank.
The third monetary policy tool involves controlling the proportion of liquid reserves that banks are required to hold. The higher the reserve requirement, the fewer funds are available for new loans. The Board of Governors has authority to establish reserve requirements above the legal minimum for all federally insured financial institutions. Reserve requirements can be changed by a simple majority vote of the Board. In practice, however, reserve requirements are rarely altered because even small adjustments produce large impacts on the quantity of required reserves throughout the banking system.
Private banks were able to maintain their own regional reserve bank rates despite pressure from Washington to centrally manage credit growth. This ultimately led to a standardized policy on the discount rate and paved the way for a decentralized Federal Reserve System. During the 1920s, open market operations evolved into a major instrument of monetary policy under Benjamin Strong, head of the Federal Reserve Bank of New York.
"From decentralized origins to Banking Act of 1935"
"Federal Statistical System's role in policy support"
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