What Is the Federal Reserve System?

Low angle view of a government building, Federal Reserve Building, Washington DC, USA
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When countries issue currency, especially fiat currency that is not specifically backed by any commodity, it is necessary to have a central bank whose job it is to monitor and regulate the supply, distribution, and transacting of currency.

In the United States, the central bank is called the Federal Reserve. The Federal Reserve currently consists of the Federal Reserve Board in Washington, D.C., and twelve regional Federal Reserve banks located in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, San Francisco, and St. Louis.

Created in 1913, the history of the Federal Reserve represents the federal government’s  ongoing effort to achieve the goals of any central banking system — ensure a secure American financial system by maintaining a stable currency backed by the benefits of high employment and minimal inflation. 

Brief History of the Federal Reserve System

The Federal Reserve was created on December 23, 1913, with the enactment of the Federal Reserve Act. In crafting the landmark legislation, Congress was responding to a series of economic panics, bank failures, and credit scarcity that had plagued the nation for decades.

When President Woodrow Wilson signed the Federal Reserve Act into law on December 23, 1913, it stood as a classic example of an all-too-rare politically bipartisan compromise balancing the need for a consistently regulated centralized national banking system with the competing interests of established private banks backed by a strong “will of the people” populist sentiment.

Over the more than 100 years since its creation, responding to economic disasters, such as the Great Depression in the 1930s and the Great Recession during the 2000s, have required the Federal Reserve to expand its roles and responsibilities.

The Federal Reserve and the Great Depression

As U.S. Representative Carter Glass had warned, years of speculative investments led to the disastrous “Black Thursday” stock market crash of October 29, 1929. By 1933, the resulting Great Depression had resulted in the failure of nearly 10,000 banks, leading newly inaugurated President Franklin D. Roosevelt to declare a banking holiday. Many people blamed the crash on the Federal Reserve’s failure to stop the speculative lending practices quickly enough and for its lack of an in-depth understanding of monetary economics necessary to implement regulations that might have lessened the devastating poverty resulting from the Great Depression.  

In response to the Great Depression, Congress passed the Banking Act of 1933, better known as the Glass-Steagall Act. The Act separated commercial from investment banking and required collateral in the form of government securities for Federal Reserve notes. In addition, Glass-Steagall required the Federal Reserve to examine and certify all banking and financial holding companies.

In a final financial reform, President Roosevelt effectively ended the long-standing practice of backing U.S. currency by physical precious metals by recalling all gold and paper silver certificates, effectively ending the gold standard.

Over the years since the Great Depression, the duties of the Federal Reserve expanded significantly. Today, its responsibilities include supervising and regulating banks, maintaining the stability of the financial system and providing financial services to depository institutions, the U.S. government, and foreign official institutions.

How Does the Federal Reserve System Work?

The Federal Reserve system is overseen by a seven-member board of governors, with one member of this committee chosen as the chairman (commonly known as the Chairman of the Fed). The president of the United States is responsible for appointing Fed chairmen to four-year terms (with confirmation from the Senate), and the current Fed chair is Janet Yellen. (The regular members of the board of governors serve fourteen-year terms.) The presidents of the regional banks are appointed by each individual branch's board of directors.

The Federal Reserve system serves a number of functions, which generally fall into a couple of categories: first, it is the Fed's job to ensure that the banking system stays responsible and solvent. While this does sometimes mean that the Fed has to work with the three branches of government to think about explicit legislation and regulation, it more often means that the Fed works in a transactional sense to clear checks and to act as a lender to banks that want to borrow money themselves. (The Fed does this mainly to keep the system stable and is referred to as the "lender of last resort," since the process is not really encouraged.)

The other function of the Federal Reserve system is to control the money supply. The Federal Reserve can control the amount of money (highly liquid assets such as currency and checking deposits) in a number of ways. The most common way is to increase and decrease the amount of money in the economy via open-market operations.

Open-Market Operations

Open-market operations simply refer to the process of the Federal Reserve buying and selling U.S. government bonds. When the Federal Reserve wants to increase the money supply, it simply purchases government bonds from the public. This works to increase the money supply because, as the buyer of the bonds, the Federal Reserve is giving out dollars to the public. The Federal Reserve also keeps government bonds in its portfolio and sells them when it wants to decrease the money supply. Selling decreases the money supply because the buyers of the bonds give currency to the Federal Reserve, which takes that cash out of the hands of the public.

There are two important things to note about open-market operations: first, the Fed itself isn't directly responsible for printing money. Printing money is handled by the Treasury, and there are multiple channels by which the money gets into circulation. (Sometimes, for example, the new money just replaces worn-out currency.) Second, the Federal Reserve doesn't actually create or issue the government bonds, it just handles them in secondary markets. (Technically, open-market operations could be conducted with a number of different assets, but it makes sense for the government to manipulate the supply and demand of an asset that was issued by the government itself.)

Other Monetary Policy Tools

Although not used nearly as frequently as open-market operations, there are other tools that the Federal Reserve can use to change the amount of money in the economy. One option is to change the reserve requirement for banks. Banks create money in an economy when they loan out customers' deposits (since both the deposit and the loan count as money), and the reserve requirement is the percentage of deposits that banks have to keep on hand rather than lending out. An increase in the reserve requirement, therefore, restricts the amount that banks can lend out and thus reduces the money supply. Conversely, a decrease in the reserve requirement increases the number of loans that banks can make and increases the money supply. (This, of course, assumes that banks want to lend more when they are allowed to do so.)

The Federal Reserve can also change the money supply by changing the interest rate that it charges banks when it acts as the lender of last resort. The process by which banks borrow from the Federal Reserve is called the discount window, and the interest rate that the Federal Reserve charges is called the discount rate. When the discount rate is increased, it is more expensive for banks to borrow in order to cover their reserve requirements. Therefore, a higher discount rate causes banks to be more careful about reserves and make fewer loans, which reduces the money supply. On the other hand, lowering the discount rate makes it cheaper for banks to rely on borrowing from the Federal Reserve and increases the number of loans they are willing to make, thus increasing the money supply.

Decisions regarding monetary policy are handled by the Federal Open Market Committee, which meets approximately every six weeks in Washington in order to discuss changing the money supply and other economic issues.

Updated by Robert Longley