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Federal Reserve Essay

The United States took over a hundred and twenty years to prefect a working banking system that could adequately adjusts to the constantly changing economy. The Federal Reserve System most important purpose is to preserve a stable economy in the US. The focus on monetary policy is to protect the purchasing power of the dollar and to encourage conditions that promote sustainable economic growth and high employment. The Federal Reserve System is a network of committees working together to ensure a productive unified monetary policy for the United States that is flexible with the ups and downs of in the business.

This network oversees the banking industry to protect the security of the monetary policy. At the birth of the Nation there was a need for one central bank to oversee and control all the banks in the United States. The Bank of the United States was given a charter to be the first central bank by Alexander Hamilton in 1791. Due to the longstanding mistrust farmers held for the banking industry, the idea of one bank holding such immense power was not well received and when the twenty-year charter was due for renewal in 1811, the United States Congress voted it down.

Recognizing the need for a central banking authority, the United States Congress voted to begin the Second Bank of the United States in 1816. Much like the Bank of the United States, the Second Bank of the United States was given a twenty-year charter. It was more powerful than the previous central bank and was not only supported, but was met with significant opposition by the citizens of the United States. Its charter was allowed to expire in 1836 (Andelman 48). The U. S. banking systems proved to be unable to respond adequately or flexibly to the variances in business cycles.

Under the National Bank Act of 1864, the countrys banking system was divided into three groups: central reserve city banks, reserve city, and country banks. The central reserve city banks were first located in New York and then Chicago and Saint Louis were added in 1887. The reserve city banks were located in sixteen other large cities. All of the national banks were required to hold reserves, while country banks were allowed to hold a percentage of these deposits in reserve city banks. When the various country banks required some additional reserves, in order to meet their customers cash demands, they would call on the reserve city banks.

These banks would then demand funds from the central reserve city banks. Any weak section in this particular system threatened a collapse to the entire system. Additional funds could not be created anywhere, and postponement of gold coin payments was the most predominant consequence. In the United States, the Resumption Act had restored the gold standard in 1879, and the Gold Standard Act of 1900 had established gold as the ultimate standard of value (Crabbe 423). Many banking crises occurred in 1873, 1883, 1893, and 1907.

It was, however, the panic of 1907 that led to the formation in 1908 of a bipartisan congressional body, titled the National Monetary Commission, whose report then set the stage for the Federal Reserve Act of 1913 and a decentralized, adaptable banking system (423). The reason for the need was made evident when the First World War nearly demolished the international gold standard (Crabbe 423). Although it was not until 1917 that the United States entered the war, the outbreak of war in Europe in 1914 immediately disrupted the U. S. financial and commodity markets.

The commodity markets were heavily dependent on London for the financing of exports. As Europe was preparing for war, the worlds financial markets became highly disorganized, especially after acceptance and discount houses in London shut down their operations. Late in July of 1914, as foreigners began liquidating their holdings of U. S securities and as U. S. debtors were desperately trying to meet their obligations to pay in sterling, the dollar-pound exchange rate soared as high as $6. 75, which was far above the average of $4. 8665 (Parley 957).

The premium on sterling made exports of gold highly profitable to use which caused an explosion of gold flowing out of the US. Under the pressure of heavy foreign selling, stock prices fell sharply in New York. The banking and financial systems in the United States seemed on the verge of collapse (Crabbe 424). On July 31, the New York Stock Exchange joined with the worlds other major exchanges and closed its doors. This eased pressure on the gold standard by preventing the export of gold arising from foreign sales of U. S. corporate securities.

In August, the unsafe shipping conditions and the unavailability of insurance slowed gold exports even further. Although the export sector was in mayhem and with $500 million in short-term debts outstanding due soon to Europe, the United States needed to take additional actions to preserve the exchange value of the dollar (Crabbe 424). The most significant relief measure came on August 3, 1914 when the Secretary of the Treasury, William McAdoo, authorized the national and state banks to issue emergency currency by invoking the Aldrich-Vreeland Act.

In light of the fact that it allowed banks to use such notes to meet currency withdrawals, and to further safeguard reserves, this extreme measure kept panic from sweeping over the banking system, and the country. In early September, less than a month after its first members took the oath of office, the Federal Reserve Board, in conjunction with the Secretary of the Treasury, organized a syndicate of banks that subscribed $108 million in gold to pay U. S. indebtedness to Europe (Crabbe 425).

One of the most interesting facts surrounding the beginnings of the Federal Reserve in November 1914 to signing the Armistice, November 1918, was that wholesale prices in the United States doubled, and the money supply grew 70 percent (Crabbe 423). Under any normal conditions, a huge credit expansion, combined with sizable inflation, would likely have endangered the gold standard. However, the flood of gold imports during this period of U. S. neutrality had urged the ratio of gold reserves to deposit and Federal Reserve note liabilities to 84. ercent in March 1917 (Crabbe 424).

Although the gold reserve ratio declined fairly steadily after the United States entered the war, it stood at 48. 3 percent at the end of the war, which was more than enough to meet the legal minimum (Crabbe 243-425). The Great Depression was also a time of great upheaval and change, in relationship to the Federal Reserve System. Samuelson states that, during the Great Depression, prices dropped by almost one-quarter between 1929 and 1933 (Samuelson 32). As prices collapsed, borrowers could not repay loans.

Lower prices had reduced their incomes. When borrowers defaulted, banks became insolvent. The failure of some banks spread the fear that other banks would fail. Depositors withdrew funds, which prompted banks to reduce loans. More firms and farms went bankrupt. The economy got worse, forcing down prices more and accelerating the vicious circle. The Great Depression stemmed from this credit collapse, about two-fifths of U. S. banks failed between 1929 and 1933 (32). The Great Depression, however, is not the only incident that illustrates the perils of an unstable market system.

While it was perhaps the most obvious and influential, there have been other smaller incidents as well. Under the late 19th centurys gold standard, where paper currency could theoretically be exchanged for gold coin, the limited amounts of gold meant that the nations currency did not expand adequately to meet the many needs of a growing economy. Repeated business failings pushed prices down, and between 1865 and 1896, the cumulative wholesale price decline was decidedly more than half. Money was not stable then, when declining prices meant that moneys value was rising.

The Populist farmers and small businessmen felt strongly that a system that required them to repay their loans in hoarded dollars was unfair (33-34). The more recent inflation repeats the basis pattern: as price changes accelerated events quickly took on a momentum of their own and moved out of governments control (Samuelson 32). Cooper and Madigan state that in todays economy recession is doubtful unless there is a huge decrease in the US expansion or in the commodity prices (23). Today the Federal Reserve System is the central banking system of the United States and is most commonly referred to as Fed.

An individual central bank serves as the banker to the banking community and also to the government. In addition, it issues the national currency, regulates any monetary policy, and is a prevalent role in the supervision and regulation of banks and bank holding companies. Within the U. S. these functions are the responsibilities of certain key officials of the Federal Reserve System. These key officials are the Board of Governors, located in Washington, D. C. , and the top officers of the 12 district Federal Reserve banks, located in various spots throughout the nation.

Andelman states that, Its function is not limited to dollar control flow in the country but more significantly, it regulates the interest rates and influences the setting of the American economic landscape, but for the most part the Federal Reserves basic powers are focused in the Board of Governors, which is predominant in all policy issues concerning bank regulation and supervision and in most aspects of monetary control (48). The Federal Reserve System does the work that is necessary in any monetary system. It processes checks, serves as a clearinghouse for bank transaction processes.

Treasury securities transactions, and lends money. It determines the interest rate for loans to commercial banks, selects the required reserve ratio which determines how much of customer deposits a banks must keep on hand. This affects how much new credit the bank can create, and also decides how much new currency Federal reserve banks may issue each year. It releases coins and currency notes produced by the Treasury Department, to the commercial banking system. The demand for money by the public varies from day to day and from week to week. There are even differences from season to season.

Banks are usually first to feel the impact of the public’s demand for cash. To meet these needs, banks turn to their regional Federal Reserve Bank for coins and currency when their supplies are low (Andelman 49-52). The Federal Reserve Banks are used to clear checks, to lend money to banks that are temporarily strapped for reserves, to issue currency, and to hold member banks reserve deposits. Today the Fed has four basic functions. An important function is conducting the nation’s monitory policy by influencing the supply of money and credit.

They must also regulate and supervise the United States financial institutions, banking operations and protect the credit rights of consumers. A third function is the Fed serve as the banker and fiscal agency for the United States. Finally the Fed supply payment services to the public through depository institutions (The Federal Reserve System 3). All four roles are important in maintaining a stable growing economy, but influencing the supply of money and credit know as monetary policy is the most important and probably the function that are people are most familiar with.

Monetary policy is the strategic actions taken by the federal reserve to influence the supply of money and credit in order to foster price stability and maintain economic growth. In this way, the Fed helps keep the national economy strong. This influence over monetary policy is the Feds real authority, and the reason for its enormous prominence in the financial world. The Feds main purpose regarding monetary policy is to ensure that enough money and credit are available to sustain economic growth without inflation.

If there are signs that inflation is threatening the US purchasing power, the Fed may need to slow the growth of the money supply. It does this by using three tools: the discount rate, reserve requirements and most important, open market operations. Two main committees direct Fed policies. They are the Board of Governors and the Federal Open Market committee. Two other organizations assist the Fed board. The Federal Advisory Council advises the board on business and financial conditions, and the Consumer Advisory Council advises the board on its responsibilities under consumer credit protection laws (The Federal Reserve System 4).

The Board of Governors was established as a federal agency. It is made up of seven members appointed by the President and confirmed by the Senate. The full term of a member is fourteen years with appointments staggered so that the terms expire on January 31 of each even-number year. The chairman of the Board is appointed for a four-year term that starts midway through each presidential term. The board monitors domestic and international financial economic developments. A Washington staff of about one thousand and seven hundred people supports the Board.

The Board is audited annually by a major public accountant firm and is also subject to audit by the General Accounting Office, an arm of Congress (Andelman 54). The Federal Open Market committee (FOMC) exercises an influence over monetary policy. FOMC sets Fed policy for trading government securities (Treasury bills, Treasury bonds and Treasury notes) and it is responsible for open market operations. The committee consists of the Board of Governors, the presidents, who serves on a rotating basis, although all members participate fully in deliberations. The Federal Open Market meets eight times a year.

The meetings usually feature summaries of international economic developments, reports on conditions in the domestic financial markets and the banking system. The Fed also gives a presentation on the United States economy as a whole and a forecast for the future. Policy options are discussed and votes are taken to decide whether or not the Fed will act. Reserve Bank boards of directors research departments and regional business leaders contribute vital information and insight that are used to formulate monetary policy. Both the public and the private sectors contribute to these decisions (The Federal Reserve 35-41).

Open market operations is the buying and selling of United States Government securities on the open market for the purpose of influencing short term interest rates and the growth of money and credit. If there is a need for an increase in the growth rate of the money supply, credit is needed, or a downward pressure on short-term interest rates, the Fed buys securities from brokers or dealers, which adds money to the reserve accounts of the banks of brokers or dealers. Then the banks credit the accounts of the brokers and dealers, which increases the amount of money and credit available in the market.

Whenever the growth of money and credit needs to be slowed down, the Fed sends securities to brokers and dealers, taking payment by debiting the accounts of banks of the brokers and dealers. Reserves leave the banking system, which reduces the money supply and cuts back the expansion of credit. Even though the Fed has enormous influence over the financial markets, it cannot force banks to raise or lower interest rates, which have remained at historically high levels ever since the early 1980’s. The Fed does not control the market, but it does hold sway over short-term interest rates because it is influenced by the open markets operations.

Its a vital participant in providing a strong central bank during times of crisis (Cooper & Madigan 24). The discount rate is the interest rate at which banks can borrow from the Federal Reserve System for short-term liquidity needs. The discount rate is changed infrequently and can discourage or encourage financial institutions lending and investment activities. It is usually lower than the Federal Funds Rate because troubled institutions can borrow to get them through short periods of problems. Originally, it was designed to help end “runs on the bank.

Banks only borrow in this way if they need the help. The reserve requirement is the percentage of deposits in demand deposit account that financial institutions must set aside and hold in reserve. If the Fed raises the reserve requirement, banks have less money to lend, which slow the growth of the money supply. If the Fed lowers the reserve requirement, banks have more money to lend and the money supply increases. The Federal Reserve System is responsible for providing the total amount of reserves consistent with the monetary needs of the economy at reasonable stable prices.

Changes in the volume of reserves influence the money supply, the available credit, and interest rates. As result, the volume of spending Depository institutions feel the impact of changes first, but the effects spread quickly to the entire financial structure of the nation, the domestic economy and often to the international economy as well. The board proclaims the Feds policies on monetary, as well as banking, matters. On account of the fact that the board is not an operating agency, a majority of the day-to-day implementation of policy decisions is given to the district Federal Reserve banks.

The stock in these banks is owned by the commercial banks that are members of the Federal Reserve System. However, ownership in this instance does not necessarily imply control, for the Board of Governors, and the heads of the Reserve banks, normally orient their policies toward public interest rather than to the advantage of the private banking system (Andelman 55). At the foundation of the Federal Reserve System are the individual member commercial banks. Every national bank is required to join the system, although membership of state-chartered institutions is voluntary.

Each member is required to purchase capital stock in his or her individual district Reserve bank. The benefit is that they are entitled to a sanctioned six percent stock dividend and also the right to vote for the directors of that particular district bank. The Monetary Control Act of 1980 ordained a reserve requirement on all depository institutions, but at the same time also permits them to borrow from the Federal Reserve and to acquire payment-mechanism services from the Fed (The Federal Reserve System).

In addition, the act mandates that the Federal Reserve charges a fee for all services provided. By enabling these banks to borrow reserves from the Reserve banks, the liquidity of the entire banking system is further increased. The twelve individual districts Reserve banks are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Georgia, Chicago, St. Louis, Minneapolis, Kansas City, Missouri, Dallas, and San Francisco. Each one of these banks is formally responsible to a nine-member board of directors. This board of directors is divided into three unique classes.

The member banks elect Class A and B directors; the Board of Governors appoints class C directors. The board of directors is responsible for the administration of the individual bank and for appointing the banks president and vice president, which is subject to the approval of the Board of Governors. In addition, the directors set the discount rate, which is also subject to review by the Board of Governors (Federal Reserve System 7-10). The Fed also has many various responsibilities for writing rules or enforcing a number of major laws that offer consumers protection in their financial dealings.

The Fed enforces truth in lending, which ensures that accurate information on the cost of credit is available to consumers. They make sure everyone has equal credit opportunity, which prohibits discrimination in lending. The Federal Reserve System ensure there are home mortgage disclosures, which requires depository institutions to disclose the geo-graphic distribution of their mortgages and home improvement loans. In the age of technology the Fed also take on the responsibility of electronic fund transfers.

They identify the rights, liabilities and responsibilities of consumers and financial institutions for electronic transfer services, such as automated teller machines, ATMs. An important law the Federal Reserve enforces is the Community Reinvestment Act. The Fed discourages red lining. The depository institutions are expected by the Fed to help meet the credit needs of all segments of their communities, including low- and moderate-income neighborhoods (Samuelson 37-39).

Sometimes the Federal Reserve is thought of as a fourth branch of the U. S. vernment because it is composed of a powerful group of national policymakers that are free from the usual restrictions of governmental checks and balances. And in fact, the Board of Governors is formally independent of the executive branch of the government and protected by tenure far beyond that allotted to the president. A very unique working relationship has evolved between the two as the Federal Reserve works in accordance with the objectives of economic and financial policy that is established by the executive branch of the government (Andelman 48).

The relationship that exists between the Federal Reserve and Congress is a bit more complex. On one hand, the central bank is clearly a component of Congress, being responsible to it for its mandate and its continued existence, while on the other hand, the self-financing characteristic of the Federal Reserve takes away from Congress its primary source of influence, which is the agency budget. In this way the Federal Reserve is somewhat free from partisan political pressures, although it must report quite frequently to the Congress on the conduct of monetary policy (Samuelson 33).

The United States has the Federal Reserve System set into place to protect the well being of the country. History has proven in order to have a healthy economy there is a need to have powerful central network to maintain the economy. Therefore without proper structure in some form, this country would no longer be the powerful nation it is today. The United States is able to provide support and structure to other nations of the world. While the system is by no means a perfect one, it is essentially stable for the most part, providing a sense of security for the entire country, if not the entire world.

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