I would like to start this paper by giving a clear definition of the federal reserve system: The Federal Reserve System most well known as “the Fed” is the central banking system and monetary authority of the United States. The Fed is made up of regional Federal Reserve banks and the Federal Reserve Board of Governors, which their main responsibility is to supervise and to examine the state-chartered member banks, also to regulate banks holding companies, and finally to be responsible for the conduct of the monetary policy. Furthermore, some of the most important duties of the Fed are to keep full employment and to maintain a low state of inflation (CPI= 2%).
In order to clearly understand this concept and its purpose, it is also necessary to give a clear definition of the word money. As stated in the Webster dictionary, money is: “A commodity, such as gold, or an officially issued coin or paper note that is legally established as an exchangeable equivalent of all other commodities, such as goods and services, and is used as a measure of their comparative values on the market.” Money has three basic functions: a medium of exchange, a measure of value, and a store of value. Goods and services are paid for in money and debts are brought upon and then paid off in money. Without money, economic transactions would have to take place on a trading basis. In conclusion, money is a good thing for Humanity. It frees people from spending too much time running around exchanging goods and services and allows them to undertake other activities such as pleasure, production, relaxation, contemplation, and temptation.
Back in the early nineteenth century the United States was experiencing a major national banking crisis. One of the most remembered crises of the United States history was the Banking Panic of 1907. Abram P. Andrew, secretary of the National Monetary Commission collected nearly two hundred samples of different bank currencies created to stem the 1907 panic, and he provided a description of the banks’ problems at that time. The banks were so singularly unrelated and independent of each other that the majority of them had simultaneously engaged in a life and death contest with each other, forgetting for the time being the solidarity of their mutual interest and their common responsibility to the community at large.
Two-thirds of the banks of the country entered upon an internecine struggle to obtain cash, had ceased to extend credit to their customers, had suspended cash payments and were hoarding such money as they had. What was the result? Thousands of men were thrown out of work, thousands of firms went into bankruptcy, the trade of the country came to a standstill, and all this happened simply because the credit system of the country had ceased to operate. With all of the troubles that the banking system was experiencing, President Woodrow Wilson passed an act in 1913 that established the Federal Reserve System (the Fed). Passing that act was the most drastic banking reform in the country’s history.
The Federal Reserve Act of 1913 was made to serve as a lender-of-last-resort in times of crisis and to provide a national currency that would expand and contract as needed. A seven member Board of Governors was established to the Fed. They are usually bankers or economic specialists that are appointed by the President with the advice and consent of the Senate to 14-year terms. The terms are so long so that the members are protected from all of the political material that goes on. The President then selects a chairman of the board who is the chief spokesperson of the Fed. As we all know, the current chairman is Alan Greenspan. He is the most powerful person in the world concerning monetary policies. There is a famous saying that “when Alan Greenspan speaks, Wall Street listens.” I personally believe that he is even more important than the president of the United States. Greenspan is the only person that has enough power to move billions and billions of dollars with just a simple speech. The Federal Reserve System is also dubbed with the name The Central Bank of the United States.
Today, the Fed is comprised of twelve regional Federal Reserve Banks spread across the United States. They are located in New York, St. Louis, San Francisco, Chicago, Atlanta, Cleveland, Dallas, Philadelphia, Richmond, Minneapolis, and Kansas City. Technically, each Federal Reserve Bank is privately owned by the member banks in its district, the very bank it is charged with supervising and regulating. Also, each member bank is required to buy stock in its district Federal Reserve Bank. This is equal to 6 percent of its own capital and surplus. Furthermore, of this 6 percent, 3 percent must be paid in and 3 percent is subject to call by the board of governors. If you look on the left side of a dollar, you can see which branch it was manufactured at. Each branch acts as a central bank for private banks in their region. Back in 1980 The Monetary Control Act resulted that all banks are subject to regulation of the Federal Reserve. Before this act, banks could choose whether or not they wanted to be “members” of the Fed. After the act was passed, all banks are required to be a “member”.
The Fed has three main policies in which they influence the way banks operate. They are the legal reserve requirement, the discount rate, and open-market operations. Each policy powers the reserve and lending capability of banks. The discount rate is not usually a potent control, but it is important for it may point to the direction that the Federal Reserve policy goes. The legal reserve ratio is a powerful policy, but changes in it are rare. Open-market operations have a direct impact on the market and are one of the most important ways the Fed controls the money supply.
The legal reserve ratio is the ratio of cash reserves to demand deposits that banks are required to maintain. When the ratio goes up excess reserves get reduced which in turn reduces the lending possibilities of banks. Banks that loan out all of their excess reserves are required by the Fed to reduce loans and borrow from the Fed or from other banks with excess reserves in order to meet a higher reserve requirement. When the legal reserve ratio goes down, it increases excess reserves, which increases the lending possibility of banks.
The discount rate is the rate of interest that the Federal Reserve Bank charges other banks when banks borrow from them. If the discount rate goes up, it will persuade private banks to borrow less. That will then lower the private banks excess reserves and force the banks to raise their interest rates for any loan. The Fed will increase the discount rate only when they want to slow down the growth in the money supply. On the other hand, when the Fed reduces the discount rate it will ease the money supply and credit. Occasionally when the discount changes, it can be viewed as a signal of whether the Fed is going to pursue a policy of monetary ease or monetary tightness.
Open-market operations are the purchases and sales of government securities by the Federal Reserve Open Market Committee (FOMC) in order to control the growth in the money supply. It also puts an influence on bank reserves, loans, and demand deposits. To obtain an open-market purchase, the Fed buys federal securities from banks or from the non-bank public. Whoever the Fed buys from, the banks excess reserves are increased. The main reason the Fed buys federal securities from banks is to increase excess reserves and to decrease federal securities held by banks. The major influence of an open-market purchase from non-banks is to increase demand deposits and excess reserves of banks.
The FOMC makes the decision to buy federal securities when they want to expand the money supply. An open-market sale is just the opposite. Excess reserves and the lending possibilities of banks are forced down by an open-market sale. Therefore, the FOMC decides to sell federal securities when they want the money supply to go down.
The act passed in 1913 by President Woodrow Wilson was one of the countries most essential banking reforms yet. The creation of the Federal Reserve System put the country bank system in order where it should be. With the new central bank the public can now trust banks again and help the economy grow to the potential it now has.
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