Federal Reserve System: What It Is and How It Work
What Is the Federal Reserve System (FRS)?
The Federal Reserve System (FRS) is the central bank of the United States. Often simply called the Fed, it is arguably the most powerful financial institution in the world. It was founded to provide the country with a safe, flexible, and stable monetary and financial system. The Fed has a board that is comprised of seven members. There are also 12 Federal Reserve banks with their own presidents that represent a separate district.1
- The Federal Reserve System is the central bank and monetary authority of the United States.
- The Fed provides the country with a safe, flexible, and stable monetary and financial system.
- The Federal Reserve System is composed of 12 regional Federal Reserve Banks that are each responsible for a specific geographic area of the U.S.1
- The Fed’s main duties include conducting national monetary policy, supervising and regulating banks, maintaining financial stability, and providing banking services.
- The Federal Open Market Committee is the Fed’s monetary policy-making body and manages the country’s money supply.
Understanding the Federal Reserve System (FRS)
A central bank is a financial institution given privileged control over the production and distribution of money and credit for a nation or a group of nations. In modern economies, the central bank is usually responsible for the formulation of monetary policy and the regulation of member banks. The Fed is composed of 12 regional Federal Reserve Banks that are each responsible for a specific geographic area of the U.S.1
The Fed was established by the Federal Reserve Act, which was signed by President Woodrow Wilson on Dec. 23, 1913, in response to the financial panic of 1907.23 Before that, the U.S. was the only major financial power without a central bank. Its creation was precipitated by repeated financial panics that afflicted the U.S. economy over the previous century, leading to severe economic disruptions due to bank failures and business bankruptcies. A crisis in 1907 led to calls for an institution that would prevent panics and disruptions.
The Fed has broad power to act to ensure financial stability, and it is the primary regulator of banks that are members of the Federal Reserve System. It acts as the lender of last resort to member institutions that have no other place from which to borrow. Often referred to simply as the Fed, it has the mandate to ensure there is financial stability in the system. It is also the main regulator of the country’s financial institutions.
The system’s 12 regional Federal Banks are based in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.1
The Fed’s main income source is interest charges on a range of U.S. government securities it has acquired through its open market operations (OMO). Other income sources include interest on foreign currency investments, interest on loans to depository institutions, and fees for services—such as check clearing and fund transfers—provided to these institutions. After paying expenses, the Fed transfers the rest of its earnings to the U.S. Treasury.4
The Federal Reserve payments system, commonly known as the Fedwire, moves trillions of dollars daily between banks throughout the U.S. Transactions are for same-day settlement.5 In the aftermath of the 2008 financial crisis, the Fed has paid increased attention to the risk created by the time lag between when payments are made early in the day and when they are settled and reconciled. Large financial institutions are being pressured by the Fed to improve real-time monitoring of payments and credit risk, which has been available only on an end-of-day basis.
The Federal Reserve System’s Mandate and Duties
The monetary policy goals of the Federal Reserve are twofold: to foster economic conditions that achieve stable prices and maximum sustainable employment.6
The Fed’s duties can be further categorized into four general areas:
- Conducting national monetary policy by influencing monetary and credit conditions in the U.S. economy to ensure maximum employment, stable prices, and moderate long-term interest rates.
- Supervising and regulating banking institutions to ensure the safety of the U.S. banking and financial system and to protect consumers’ credit rights.
- Maintaining financial system stability and containing systemic risk.
- Providing financial services, including a pivotal role in operating the national payments system, depository institutions, the U.S. government, and foreign official institutions.
The Federal Reserve System’s Organizational Structure
There are seven members of the Board of Governors. These individuals are nominated by the President and approved by the U.S. Senate. Each governor serves a maximum of 14 years. Their appointment is staggered by two years to limit the power of the president.7 The law also dictates that appointments represent all broad sectors of the U.S. economy.
Note that as of June 7, 2022, only one board seat remains empty.8
|Fed Governors (as of June 2022)|
|Chair||Jerome H. Powell|
|Board Member||Michelle W. Bowman|
|Board Member||Lisa D. Cook|
|Board Member||Philip N. Jefferson|
|Board Member||Christopher J. Waller|
|Board Member||Seat Currently Empty|
In addition to the governors of the Fed’s board, each of the 12 regional banks has its own president. Each of these banks is set up in a different Federal Reserve district.1
|Fed Regional Bank Presidents (as of June 2022)|
|Name of President||Bank Location-District|
|Kenneth C. Montgomery||Boston-1|
|John C. Williams||New York-2|
|Patrick T. Harker||Philadelphia-3|
|Loretta J. Mester||Cleveland-4|
|Thomas I. Barkin||Richmond-5|
|Raphael W. Bostic||Atlanta-6|
|James Bullard||St. Louis-8|
|Esther L. George||Kansas City-10|
|Mary C. Daly||San Francisco-12|
The Federal Reserve System’s Independence
Central bank independence refers to the question of whether the overseers of monetary policy should be completely disconnected from the realm of government. Those who favor independence recognize the influence of politics in promoting monetary policy that can favor re-election in the near term but cause lasting economic damage down the road. Critics say that the central bank and government must be tightly coordinated in their economic policy and that central banks must have regulatory oversight.
The Fed is also considered to be independent because its decisions do not have to be ratified by the president or any other government official. However, it is still subject to congressional oversight and must work within the framework of the government’s economic and fiscal policy objectives.
Fears over the expansion of the Federal Reserve balance sheet and risky bailouts for firms such as American International Group (AIG) have led to demands for increased transparency and accountability.9 Recent calls in Washington to audit the Federal Reserve could potentially undermine the independent status of the U.S. central bank.
The Fed is considered to be independent because its decisions do not have to be ratified.
The Federal Reserve System (FRS) vs. Federal Open Market Committee (FOMC)
The Federal Reserve’s Board of Governors is responsible for setting reserve requirements. This is the amount of money banks are required to hold to ensure they have enough to meet sudden withdrawals.10 It also sets the discount rate, which is the interest rate the Fed charges on loans made to financial institutions and other commercial banks.11
The Federal Open Market Committee (FOMC), on the other hand, is the Federal Reserve’s main monetary policymaking body. It is responsible for open market operations including the buying and selling of government securities. The FOMC includes the Board of Governors (or the Federal Reserve Board (FRB) as it’s also called), the president of the Federal Reserve Bank of New York, and the presidents of four other regional Federal Reserve Banks who serve on a rotating basis.12
The committee is responsible for monetary policy decisions, which are categorized into three areas: maximizing employment, stabilizing prices, and moderating long-term interest rates. The first two are known as the Fed’s dual mandate.13
Central banks across the globe, including the Fed, have also come to use a tool known as quantitative easing (QE) to expand private credit, lower interest rates, and increase investment and commercial activity through FOMC decision-making. Quantitative easing is mainly used to stimulate economies during recessions when credit is scarce, as it was during and following the 2007-2008 financial crisis, for example.
What Does It Mean That the Federal Reserve Is a Central Bank?
A central bank is a financial institution that is responsible for overseeing the monetary system and policy of a nation. A central bank regulates the money supply and sets a nation’s interest rates. Central banks also enact monetary policy. By easing or tightening the money supply and availability of credit, central banks seek to keep a nation’s economy on an even keel.
Who Owns the Federal Reserve?
The Federal Reserve System is not owned by anyone. It was created in 1913 by the Federal Reserve Act to serve as the nation’s central bank. The Board of Governors is an agency of the federal government and reports to and is directly accountable to Congress.14
Does the Fed Print U.S. Money?
Though the U.S. Treasury Department issues coins, the Fed prints and manages paper money, which is technically known as Federal Reserve notes. The Federal Reserve currently issues $1, $5, $10, $20, $50, and $100 notes. The largest denomination Federal Reserve note ever issued for public circulation was the $10,000 note.15
How Does the Fed Set Interest Rates?
The Fed has an implicit target rate of inflation of 2%.16 The principle of inflation targeting is based on the belief that long-term economic growth is best achieved by maintaining price stability, and price stability is achieved by controlling inflation. Inflation levels of 1% to 2% per year are generally considered acceptable, while inflation rates greater than 3% represent a dangerous zone that could cause the currency to become devalued. The Taylor rule is an econometric model that says the Federal Reserve should raise interest rates when inflation or gross domestic product (GDP) growth rates are higher than desired.17
Does the Fed Collect Taxes?
No. The Fed is responsible only for monetary policy and banking system oversight. Federal taxes are approved and collected exclusively by Congress—via the Internal Revenue Service (IRS), a federal agency)—which is an instance of fiscal policy. State and local taxes are collected by individual states or municipalities.
- Federal Reserve System. “The Twelve Federal Reserve Districts.”
- United States Senate. “The Senate Passes the Federal Reserve Act.”
- Federal Reserve System. “Federal Reserve Act.”
- Federal Reserve System. “What Does It Mean That the Federal Reserve Is “Independent Within the Government?“
- Federal Reserve System. “Fedwire Funds Services.”
- Federal Reserve System. “What Economic Goals Does the Federal Reserve Seek to Achieve Through Its Monetary Policy?“
- Federal Reserve System. “Federal Reserve Act: Section 10. Board of Governors of the Federal Reserve System.”
- Federal Reserve System. “Board of Governors Members, 1914-Present.”
- Federal Reserve System. “Credit and Liquidity Programs and the Balance Sheet.”
- Federal Reserve System. “Reserve Requirements.”
- Federal Reserve System. “The Discount Window and Discount Rate.”
- Federal Reserve System. “About the FOMC.”
- Federal Reserve Bank of Chicago. “The Federal Reserve’s Dual Mandate.”
- Federal Reserve System. “Most Frequently Asked Questions.”
- Federal Reserve System. “Which Denominations of Currency Does the Federal Reserve Issue?“
- Federal Reserve System. “Why Does the Federal Reserve Aim for Inflation of 2 Percent Over the Longer Run?“
- Federal Reserve System. “Policy Rules and How Policymakers Use Them.”
Prepare and write by:
Author: Mohammed A Bazzoun
If you have any more specific questions, feel free to ask in comments.
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