Functions of the Federal Reserve System

Functions of the Federal Reserve System

Function #1: Conducting Monetary Policy

The primary function of the Fed is the conduct of monetary policy. Monetary policy is the management of the nation’s money supply, interest rates, and banking system to promote economic growth, low unemployment, and low inflation.

If the Fed thinks the economy needs a stimulus (e.g., to fight unemployment), it will increase the money supply by inducing commercial banks to create more money through loans. Commercial banks are financial institutions, chartered by the federal or state government, that generate income primarily by accepting deposits from the general public and using these funds to create loans. Commercial banks are usually referred to simply as banks. Depositors are paid little or no interest on their deposited funds. Borrowers are charged moderate to high interest rates on their loans from commercial banks, however. Most commercial banks attempt to earn profits for their stockholders (i.e., the owners of the bank). Credit unions are not-for-profit organizations that provide banking services to members. Credit unions usually offer more favorable interest rates than other financial institutions. Many credits unions pay slightly higher rates of return on deposits and charge slightly lower rates of interest on loans than traditional banks.

If the Fed thinks the economy needs to slow down (e.g., to fight inflation), it will decrease the money supply by inducing commercial banks to create less money through loans.

Open market operations are the purchases and sales of government securities by the Fed to or from the general public. Monetary policy is conducted primarily through open market operations by the Federal Open Market Committee (FOMC). The FOMC meets approximately every six weeks to discuss the condition of the economy and consider changing the nation’s money supply. The 12 regional Federal Reserve Banks play an important role in monetary policy by providing economic data and research to the FOMC for its consideration. After each meeting, the FOMC directs the Open Market Desk at the Federal Reserve Bank of New York to increase, decrease or maintain the growth rate of the nation’s money supply. To increase the money supply, the Open Market Desk buys Treasury securities each day from the general public (i.e., in the open market). These transactions are open market purchases. To decrease the money supply, the Open Market Desk sells Treasury securities each day to the general public (i.e., in the open market). These transactions are open market sales.

If the Board of Governors thinks the economy needs more influence than is provided by the open market operations, it can change the discount and federal funds rates, which are the interest rates charged on loans to commercial banks. Low interest rates provide an incentive for commercial banks to create more money in the form of loans to the general public. The discount rate is the interest rate charged on loans from the regional Federal Reserve Banks to commercial banks. Loans from regional Federal Reserve Banks to commercial banks are called discount loans. The federal funds rate is the interest rate charged on loans from commercial banks to other commercial banks. The federal funds rate is one half of a percentage point less than the discount rate. Federal funds are reserves that are loaned overnight from a commercial bank with excess reserves to a commercial bank with a shortage of reserves. Reserves are explained later in this chapter.

If the Board of Governors wants to make a major adjustment to the economy, it might change the required reserve ratio. Decreasing the required reserve ratio allows commercial banks to create more money in the form of loans to the general public. Increasing the required reserve ratio causes commercial banks to create less money in the form of loans to the general public.


Function #2: Supervising and Regulating Banks

The Federal Reserve System maintains the stability of the financial system and protects the credit rights of consumers. Prior to the creation of the Federal Reserve System in 1913, the United States endured many banking panics. So to stabilize the banking system, Congress gave the Fed the responsibility to supervise and regulate banks. The Board of Governors develops the written rules that define acceptable behavior for financial institutions. The 12 regional Federal Reserve Banks supervise the enforcement of these rules by overseeing state-chartered member banks, the companies that own banks (bank holding companies) and international organizations that do banking business in the United States. The Federal Reserve System also ensures the stability of the banking system by acting as a lender of last resort. This means that if a commercial bank is in danger of going bankrupt, the Fed will provide the bank with enough funds to keep it solvent. A bank is solvent if it is able to meet its financial obligations, such as providing money to all depositors who wish to wish to withdraw their funds.






Function #3: Providing Financial Services[6]

The Federal Reserve System provides financial services to the U.S. government, the public, financial institutions, and foreign official institutions.

The Federal Reserve Banks and their branches provide a safe and efficient method of transferring funds throughout the banking system by offering banking services to all financial institutions in the United States.

Each Federal Reserve Bank provides banking services to all financial institutions in its geographic region. These services include the provision of currency as needed by the area’s financial institutions and the processing of commercial checks and other electronic payments.

The electronic payment services provided by the Fed are funds transfers and the automated clearinghouse (ACH). Funds transfers occur between financial institutions or government agencies. ACH transactions include payroll deposits, electronic bill payments, insurance payments, and Social Security distributions.

Because the Federal Reserve System provides banking services to financial institutions, such as commercial banks, the Fed is sometimes called the bankers’ bank. The Federal Reserve also provides banking services to the U.S. government. These services include the maintenance of U.S. Treasury accounts, the processing of government checks, the sale, service, and redemption of U.S. Treasury securities, savings bonds and postal money orders, and the collection of federal tax deposits.