15.2 The Federal Reserve System
- How does the Federal Reserve manage the money supply?
Before the twentieth century, there was very little government regulation of the U.S. financial or monetary systems. In 1907, however, several large banks failed, creating a public panic that led worried depositors to withdraw their money from other banks. Soon many other banks had failed, and the U.S. banking system was near collapse. The panic of 1907 was so severe that Congress created the Federal Reserve System in 1913 to provide the nation with a more stable monetary and banking system.
The Federal Reserve System (commonly called the Fed) is the central bank of the United States. The Fed’s primary mission is to oversee the nation’s monetary and credit system and to support the ongoing operation of America’s private-banking system. The Fed’s actions affect the interest rates banks charge businesses and consumers, help keep inflation under control, and ultimately stabilize the U.S. financial system. The Fed operates as an independent government entity. It derives its authority from Congress but its decisions do not have to be approved by the president, Congress, or any other government branch. However, Congress does periodically review the Fed’s activities, and the Fed must work within the economic framework established by the government.
The Fed consists of 12 district banks, each covering a specific geographic area. Exhibit 15.3 shows the 12 districts of the Federal Reserve. Each district has its own bank president who oversees operations within that district.
Originally, the Federal Reserve System was created to control the money supply, act as a borrowing source for banks, hold the deposits of member banks, and supervise banking practices. Its activities have since broadened, making it the most powerful financial institution in the United States. Today, four of the Federal Reserve System’s most important responsibilities are carrying out monetary policy, setting rules on credit, distributing currency, and overseeing payment systems including digital transactions.
Carrying Out Monetary Policy
The most important function of the Federal Reserve System is carrying out monetary policy. The Federal Open Market Committee (FOMC) is the Fed policy-making body that typically meets eight times a year to make monetary policy decisions. It uses its power to change the money supply in order to control inflation and interest rates, increase employment, and influence economic activity. Three tools used by the Federal Reserve System in managing the money supply are open market operations, reserve requirements, and the discount rate. Table 15.3 summarizes the short-term effects of these tools on the economy.
Open market operations—a key function of the Federal Reserve—involve the purchase or sale of U.S. government bonds. The U.S. Treasury issues bonds to obtain the extra money needed to run the government (if taxes and other revenues aren’t enough). In effect, Treasury bonds are long-term loans (20 to 30 years) made by businesses and individuals to the government. The Federal Reserve buys and sells these bonds for the Treasury. When the Federal Reserve buys bonds, it puts money into the economy. Banks have more money to lend, so they reduce interest rates, which generally stimulates economic activity. The opposite occurs when the Federal Reserve sells government bonds.
| The Federal Reserve System’s Monetary Tools and Their Effects | ||||
|---|---|---|---|---|
| Tool | Action | Effect on Money Supply | Effect on Interest Rates | Effect on Economic Activity |
| Open market operations | Buy government bonds | Increases | Lowers | Stimulates |
| Sell government bonds | Decreases | Raises | Slows Down | |
| Discount rate | Raise discount rate | Decreases | Raises | Slows Down |
| Lower discount rate | Increases | Lowers | Stimulates | |
The Federal Reserve is called “the banker’s bank” because it lends money to banks that need it. The interest rate that the Federal Reserve charges its member banks is called the discount rate. When the discount rate is less than the cost of other sources of funds (such as certificates of deposit), commercial banks borrow from the Federal Reserve and then lend the funds at a higher rate to customers. The banks profit from the spread, or difference, between the rate they charge their customers and the rate paid to the Federal Reserve. Changes in the discount rate usually produce changes in the interest rate that banks charge their customers. The Federal Reserve raises the discount rate to slow down economic growth and lowers it to stimulate growth.
Setting Rules on Credit
Another activity of the Federal Reserve System is setting rules on credit. It controls the credit terms on some loans made by banks and other lending institutions. This power, called selective credit controls, includes consumer credit rules and margin requirements. Consumer credit rules establish the minimum down payments and maximum repayment periods for consumer loans. The Federal Reserve uses credit rules to slow or stimulate consumer credit purchases. Margin requirements specify the minimum amount of cash an investor must put up to buy securities or investment certificates issued by corporations or governments. The balance of the purchase cost can be financed through borrowing from a bank or brokerage firm. By lowering the margin requirement, the Federal Reserve stimulates securities trading. Raising the margin requirement slows trading.
Distributing Currency: Keeping the Cash Flowing
The Federal Reserve distributes the coins minted and the paper money printed by the U.S. Treasury to banks. Most paper money is in the form of Federal Reserve notes. Look at a dollar bill and you’ll see “Federal Reserve Note” at the top. The large letter seal on the left indicates which Federal Reserve Bank issued it. For example, bills bearing a D seal are issued by the Federal Reserve Bank of Cleveland, and those with an L seal are issued by the San Francisco district bank.
Making Check Clearing Easier
Another important activity of the Federal Reserve is processing and clearing checks between financial institutions. When a check is cashed at a financial institution other than the one holding the account on which the check is drawn, the Federal Reserve’s system lets that financial institution—even if distant from the institution holding the account on which the check is drawn—quickly convert the check into cash. Transactions, through various means such as checks or ACH, drawn on banks within the same Federal Reserve district are handled through the local Federal Reserve Bank using a series of entries (often electronic) to transfer funds between the financial institutions. The process is more complex for transactions between different Federal Reserve districts.
The time between when the transaction is initiated and when the funds are deducted from the originator's account provides float. With ACH transactions, the float is greatly reduced (almost instantaneous) from what you would expect with a paper check. Float benefits the originator by allowing it to retain the funds until the transaction clears—that is, when the funds are actually withdrawn from its accounts. Check usage declined over the last decade from 6 percent to just 2.5 percent of customer transactions. It is projected that the number of check payments will continue to decline as more people exclusively use online banking and other electronic payment systems. In fact, some countries are planning to phase out checks in the coming years entirely, and the U.S. government no longer accepts or issues checks for items such as tax payments or social security benefits as of September 2025.3
Managing the Great Recession
Much has been written about the global financial crisis that occurred between 2007 and 2009. Some suggest that without the Fed’s intervention, the U.S. economy would have slipped deeper into a financial depression that could have lasted years. The Great Recession was caused by several factors including weak regulation of the mortgage market, lenders taking excess risk, and lending practices that put borrowers at risk of default. These actions, along with other economic factors, put the U.S. economy into a financial crisis.4
In the early 2000s, the housing industry was booming. Mortgage lenders were signing up consumers for mortgages that “on paper” they could afford. In many instances, lenders told consumers that based on their credit rating and other financial data, they could easily take the next step and buy a bigger house or maybe a vacation home because of the availability of mortgage money and low interest rates. This prompted a situation in which borrowers could no longer afford to pay their mortgages, and they started to default on their home loans in late 2007. The value of real estate declined, and many borrowers owed more on their loans than the home was worth, which left their investment "underwater." Many consumers were unable to keep their homes and even had to file for personal bankruptcy. At this same time, the U.S. economy was struggling, and unemployment was on the rise as companies were responding to the declining economic conditions.5
In addition, several leading financial investment firms, particularly those that managed and sold the high-risk, mortgage-backed financial products, failed quickly because they had not set aside enough money to cover the billions of dollars they lost on mortgages then going into default. For example, Bear Sterns, a large investment bank in operation since 1923, had a large portion of investments that were secured by mortgages that were going unpaid by consumers. The firm could not survive the impact and was sold to JP Morgan Chase for less than $10 per share in 2008.6
After the collapse of Bear Stearns and other firms such as Countrywide Financial and Merrill Lynch, the Fed set up a special loan program to stabilize the banking system and to keep the U.S. bond markets trading at a normal pace. The Federal Reserve made more than $9 trillion in loans to financial firms during the Great Recession. Additionally, the Federal Reserve provided emergency funding for firms in the auto industry as a "bail out" to help support the U.S. stock market.7
As a result of this financial meltdown, Congress passed legislation in the years that followed to establish more regulations in the financial industry both to protect consumers and to help prevent another recession because of risky lending practices. Among its provisions, the Dodd-Frank Wall Street Reform and Consumer Protection Act (known as Dodd-Frank) created oversight councils to track the stability of major firms in the financial industry and regulate insurance companies. The councils were given the powers to require changes, liquidate, or restructure the firms to protect the stability of the U.S. economy. Risky investments by financial firms are now also restricted. Consumers are more protected as a result of the Act with the Consumer Financial Protection Bureau. Finally, the Act established a whistle-blower provision to protect individuals who come forward to report security and financial violations.8
Another provision of Dodd-Frank legislation requires major U.S. banks to submit to annual stress tests conducted by the Federal Reserve. These annual checkups determine whether banks have enough capital to survive economic turbulence in the financial system and whether the institutions can identify and measure risk as part of their capital plan to pay dividends or buy back shares. And today this has grown to all banks, although the number of banks required to meet the standards was decreased in 2018 with the passing of the Economic Growth, Regulatory Relief and Consumer Protection Act.9
Concept Check
- What are the four key functions of the Federal Reserve System?
- What three tools does the Federal Reserve System use to manage the money supply, and how does each affect economic activity?
- What was the Fed’s role in supporting the U.S. financial markets to recovery during the Great Recession?