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The Federal Reserve System, also known as the "Fed," is an independent U.S. government agency. Its most important function is to manage the country's supply of money and credit.
The Federal Reserve System includes 12 regional Federal Reserve Banks and 25 Federal Reserve Bank branches. All nationally chartered commercial banks are required by law to be members of the Federal Reserve System; membership is optional for state-chartered banks. In general, a bank that is a member of the Federal Reserve System uses the Reserve Bank in its region in the same way that a person uses a bank in his or her community.
The Federal Reserve System is administered by the Federal Reserve Board of Governors, a group of seven individuals who are appointed by the president of the United States and serve overlapping 14-year terms. Although the Federal Reserve System is directly responsible to Congress, the governors are, by law, independent of political pressure from either Congress or the president. The board is expected, however, to coordinate its policies with those of the administration and Congress. Additionally, the Federal Reserve does not rely on Congress for funding: it raises all of its own operating expenses from investment income and fees for its own services. When a conflict arises between making a profit or serving the public interest, however, the Fed is expected to choose the latter.
The Fed's operation has evolved over time in response to major events. Established by Congress in 1913, the Federal Reserve was created to strengthen the supervision of the banking system and stop the periodic bank panics that erupted in the previous century. As a result of the Great Depression in the 1930s, Congress gave the Fed the authority to vary reserve requirements and to regulate stock market margins. In time, additional laws made it easier for the Fed to expand credit when a financial disaster seemed likely.
During World War II, Federal Reserve operations were subordinated to helping the Treasury borrow money at low interest rates. When the Korean conflict began and commercial banks sold large amounts of Treasury securities, the Fed bought heavily to keep security prices from falling. However, the Fed reasserted its independence in 1951, reaching an accord with the Treasury that Federal Reserve policy should not be subordinated to Treasury financing.
After 1951, the Fed focused more directly on domestic economic stabilization, aiming to keep interest rates low in recessionary periods and allowing them to rise in periods of rapid economic expansion. In the late 1950s, the Fed's emphasis was on price stability and restriction of monetary growth, while in the 1960s its policy stressed full employment and growth of output.
During the 1970s, credit expansion was too rapid, and mounting inflation hurt the economy. In 1979, the Federal Reserve adopted a policy aimed at more directly controlling the money supply rather than interest rates. This policy was successful in slowing the growth of the money supply, limiting the expansion of credit, and contributing to a lower rate of inflation. But it also contributed to recession in the early 1980s. In 1982, the Fed again de-emphasized the controls on money supply growth and began working to bring about lower interest rates.
The Federal Reserve has three main tools for maintaining control over the total supply of money and credit in the economy. The first is the discount rate, or the interest rate that commercial banks pay to borrow funds from Reserve Banks. By raising or lowering the discount rate, the Fed can promote or discourage borrowing and, thus, alter the amount of revenue available to banks for making loans.
The second is the reserve requirement. These are percentages of deposits, set by the Federal Reserve, that commercial banks must set aside either as currency in their vaults or as deposits at their regional Reserve Banks. These percentages cannot be used for loans. In 1980 the Federal Reserve gained the authority to set reserve requirements for all deposit-taking institutions.
The third tool, which is probably the most important, is known as open market operations. It is the buying and selling of government securities. When the Federal Reserve buys government securities from banks, other businesses or individuals, it pays for them with a check (a new source of money that it prints) drawn on itself. When this check is deposited in a bank, it creates new reserves -- a portion of which can be lent or invested -- further increasing the money supply.
These tools allow the Federal Reserve to expand or contract the amount of money and credit in the U.S. economy. When there is more money to lend, credit is "loose" and interest rates tend to drop. In general, business and consumer spending tend to rise when interest rates fall. When there is less money to lend, credit is "tight" and interest rates tend to rise. Tight money is considered a particularly powerful tool for fighting inflation
Yet certain factors complicate the ability of the Federal Reserve to use monetary policy to promote specific goals. First, it is hard to use monetary policy precisely because changes in the money supply do not cause immediate changes in the economy. An increase or decrease in the money supply may not affect the economy until other economic conditions have changed; the new conditions may interact with the change in the size of the money supply to create a totally unintended result. In fact, efforts to use monetary policy to achieve price stability sometimes have hampered efforts to achieve fuller employment, while efforts to use monetary policy to reduce unemployment sometimes have led to inflation. Additionally, the task of monetary policy is also complicated by the nation's balance of payments difficulties. For these reasons, the Federal Reserve tends to move cautiously, making very gradual changes in the money supply.