Nickel And Dimed

Final Exam chapters 13, 14 and 15 - Federal Reserve

The United States nation was overwhelmed with financial crises. These crises led the nations to the "banking panics" in which people look for their banks to withdraw must of their deposits. In 1907, a particularly panic resulted in a disaster on the fragile banking system and eventually heading for the Congress to write the Federal Reserve Act in 1913. Initially it was created to address the nation's banking panics. Then the Federal Reserve became responsible for developing a healthy economy. In order to achieve the private interests of banks and the centralized responsibilities of government, a central bank under public control was created, the Federal Reserve System.

The Federal Reserve System (the "Fed") was created on December 23, 1913. The "Fed" is consisted of the Board of Governors, the Reserve Banks and the Federal Open Market Committee. The Board of Governors is the "economic authorities", or the federal government agency that regulates banks. The Board consists of seven members to formulate the vital policy decisions that provide monetary control over the U.S. money and supervises the Reserve Banks activities. The Reserve Banks are divided into twelve districts, and which district has a regional Reserve Bank located in the closest most important cities. When working together, the twelve banks provide the nation with a "central bank" or a bankers' bank. Reserve Banks conduct research on the local economy, supervise banks in their regions and provide financial services to banks and the U.S. government. Somehow the Reserve Banks work independently but under the supervision of the Board of Governors. The Federal Open Market Committee, or FOMC, is the Fed's ruler organization for monetary policy-making. The FOMC manages the nation's money supply, the most important function of the Fed, to help the economy achieve sustainable growth. How does the FOMC control the money supply? The FOMC sets up a mark for the federal funds rate. The Federal Open Market buys government securities to increase the total reserve of money. Now, the banks have more money available to lend, which decreases the federal funds rate. In other hands, sales of government securities reduce the reserve of money available to lend, which tend to raise the funds rate. By controlling the federal funds rate, the FOMC creates the monetary incentive necessary to promote a healthy economy.

Overall in the Federal Reserve System, the Board of Governors is the federal government agency. The Reserve banks are the operational arms and the FOMC is the committee that sets monetary policy. Each part of the Federal Reserve work together to accomplish the Fed's three main responsibilities: conducting the monetary policy, supervising banks and providing financial services.

The most important function of the Federal Reserve is to keep price stability and sustainable economic growth. In order to do it, the Federal Reserve manages the money supply according to the needs of the economy, in other words, the Fed conducts the monetary policy to achieve its goals: the low inflation and the economy healthy.

How does it work? The Fed has three tools to accomplish the monetary policy goals: the open market operations, the reserve requirements and the discount rate. All three affect the amount of money in the banking system.

Undoubtedly, the most important instrument used to influence the money supply is the open market operations, which involve the buying and selling of U.S. government securities. As it was described previously, the FOMC Committee issues a directive reflecting the Committee's policy goals: easing, tightening or maintaining the growth of the money supply. Then the Federal Reserve Bank of New York sells or buys securities in the open market. The expression "open market" means that the Fed buys and sells securities to all buyers and sellers of corporate and government bonds, and various securities dealers compete on the basis of price with each other. If the Fed wants to increase reserves, it buys securities increasing the money in the banks reserves and the banks abilities to lend, and as a result creating more new money. However, when the Fed wants to reduce reserves, it sells securities retaining money from banks and reducing the abilities to lend. Since open market operations are directly involved with the amount of money and credit banks have on hands, they eventually influence interest rates and the of the U.S. economy.

There is a minor difference between the Federal Reserve Banks' purchases of securities from the commercial banking system and their purchases of securities from the public. Assume that initially all commercial banks are loaned up. The Federal Reserve security purchases from commercial banks increase the actual reserves and excess reserves of theses banks by the entire amount of the bound purchases. For example, if a $1000 bond purchase from a commercial bank increases both the actual and the excess reserves of the commercial bank by $1000.

Quite the opposite, Federal Reserve Bank acquires bonds from the public, it increases actual reserves but increase the checkable deposits as well. Because the sellers probably will deposit the Fed's check into their personal checking accounts. Consequently, a $1000 bond purchase from public increase checkable deposits and the actual reserve by $1000. However, by applying a 20 percent reserve ratio to the $1000 checkable deposit, the excess reserves of the banking system would be increased only by $800, since $200 would have to be held as reserves. However, in both transactions the end result is the same: when Federal Reserve Banks buy securities in the open market, commercial banks' reserves are increased.

The reserve ratio requirements are the portions of deposits that banks have to save. They are required to have this reserve, either in their own vaults or on deposit at a Reserve bank