The Federal Reserve: "Everyday Economics"

Read this article on the inception of the Federal Reserve system. Also learn about how this institution evolved over time to become one of the most important decision makers in our economy.

Beyond Monetary Policy

The Federal Reserve is also responsible for ensuring the U.S. payments system is efficient and effective, that it supports the economic needs of our country's citizens, and that its services are available to all commercial banks - regardless of size or location - so they can meet the payment needs of their customers. This places the Fed in the often difficult position of competing with some of the institutions it regulates and regulating the payments system in which it is an active participant. In addressing this challenge, integrity and equity are the Fed's mainstays.

The Banker's Bank

As the "banker's bank," the Fed provides services to financial institutions in much the same way commercial banks serve their customers. This role promotes the smooth functioning of the financial system, contributes to the implementation of monetary policy, and drives the efficiency and technological development of the payments system.

Every business day, Reserve Banks process billions of dollars through currency, check and electronic payments services. The money the Treasury prints or mints is put into circulation by the Fed, which also ensures that it is in good physical condition by removing from circulation notes and coins that are damaged, counterfeit or simply worn-out.

An important operation in the Fed system is check clearing. Every day, millions of checks are moved around the country, sorted, tabulated, and credited or debited to the accounts of financial institutions. To speed the collection of checks, these operations take place 24 hours a day.

Another way to increase the speed of payments collection and reduce the cost of processing and transporting paper checks is the use of electronic payments. Leading the way in electronic checking and the development of check imaging technology, the Fed's nationwide electronic network enables institutions to transfer funds to other institutions anywhere in the country within seconds. This network also serves as an infrastructure for final payment, or "settlement," between financial institutions.

The Government's Bank

In addition to these services for financial institutions, Reserve Banks serve as banks for the U.S. government by maintaining accounts and providing services for the Treasury and by acting as depositories for federal taxes. The Fed also handles the sale and redemption of original issues of government securities to assist the Treasury Department in financing the national debt. These Treasury bills, notes and bonds are sold to the public and to financial institutions.

Banking Supervision

The Federal Reserve has supervisory and regulatory authority over a wide range of financial institutions and activities. It works with other federal and state entities to promote safety and soundness in the operation of financial institutions, stability in the financial markets, and fair and equitable treatment of consumers in their financial transactions. This hands-on experience with supervision and regulation provides the Federal Reserve with essential knowledge for monetary policy deliberations and enhances the Fed's ability to forestall and/or manage financial crises as needed.

The Fed is one of four federal organizations responsible for supervising financial institutions. Federal Reserve Banks supervise bank holding companies, state member banks and certain nonbank operations. They also supervise the foreign activities of these organizations and the U.S. activities of foreign banking organizations.

Bank supervision involves the monitoring, inspecting and examining of banking organizations to assess their condition and their compliance with laws and regulations. When an institution is found to be in noncompliance or to have other problems, the Federal Reserve may use its authority to have the institution correct the situation. Bank regulation entails making and issuing specific rules and guidelines governing the structure and conduct of banking, under the authority of legislation.

The Lender of Last Resort

Through its discount and credit operations, Reserve Banks provide liquidity to banks to meet short-term needs stemming from seasonal fluctuations in deposits or unexpected withdrawals. Longer term liquidity may also be provided in exceptional circumstances. The rate the Fed charges banks for these loans is the discount rate (officially theprimary credit rate).

In making these loans, the Fed serves as a buffer against unexpected day-today fluctuations in reserve demand and supply. This contributes to the effective functioning of the banking system, alleviates pressure in the reserves market and reduces the extent of unexpected movements in the interest rates.

The Economy: The Fed as Inflation Fighter

The Fed's most important job is making sure there is enough money and credit to allow the economy to grow, but not so much money that the currency loses its value. Inflation is the continuing, broad-based rise in the price of goods and services. Put in a slightly different way, inflation is an erosion in the purchasing power, or value, of a nation's currency.

The goal of monetary policy is to fight inflation so that sustainable long-term growth can be maintained. One way of doing this is by letting the money supply grow as fast as the economy grows, but no faster. If the money supply grows too rapidly, inflation will result, reducing your purchasing power. This would mean that your dollar, which bought 100 jelly beans yesterday, might buy only 95 today. The Fed fights this decline in purchasing power by influencing the amount of money and credit flowing through the financial system. One way to relieve mounting inflationary pressures is by slowing the growth of the money supply. If the Fed expands the flow of money and credit, bankers will be able to make more loans to their customers. If money and credit are restricted, banks will have less money to lend, causing a decrease in the money supply.