The Federal Reserve

Unlike the central banks of most countries, the FED (Federal Reserve) is not one, but twelve banks, with 25 regional branches spread across the nation.

A. What is the Fed?

The Federal Reserve Bank (FRB) is the country’s national bank. Its origin goes back to 1907, when a sudden nationwide financial scare resulted in a disastrous run on the banks. J. P. Morgan saved the day by importing $100 million worth of gold from Europe. The government, however, decided it could not continue to rely on industry giants to save the economy. In 1913, Congress created the Federal Reserve to stabilize and secure the nation’s financial system. Since then, the trend has increased toward coordination. Today, all banks are part of the Federal Reserve System.

B. Who runs the Federal Reserve?

The Fed is run by a seven-member Board of Governors appointed by the President and confirmed by the senate. No two members may come from the same Federal Reserve District. Terms of office last 14 years to insulate governors from political pressures. Terms are staggered with one expiring every two years. There is one chairman and one vice-chairman, both of whom hold terms of four years.

C. Facts about the Fed

1) The fed is not an agency of the US government. It is a corporation accountable to the government but owned by banks which have purchased shares of stocks.

  1. The FDICsymbol displayed in a bank does not mean the bank is a member of the Fed.
    1. Fort Knox is not a member of the Federal Reserve. It Is a US military installation where much of the nation’s gold is stored. Most gold stored by the Fed is foreign-owned.

D. What does the Fed Do?

1)  The Bankers Bank

If a bank wants to lend money to customers, it may need to borrow money from its own bank – the Fed. The interest rate the Fed charges bank is called the Discount Rate.

2) The watchdog

The Fed is also the banks’auditor. Fed officials regularly examine every banks’ records to make sure loan decisions are based on sound judgment and that regulations are being followed.

3) The regulator of money supply

The Fed tries to maintain the right balance of money so the dollar will buy roughly the same amount of goods and services every year. If prices remain stable, so will the value of our money.

4)  The controller of the currency

As coins and paper money become damaged, the Fed takes them out of circulation and orders the Treasury to replace them with fresh new coins and bills.

5) The US government’s bank

The Fed, through the Reserve Banks, is where the Treasury has its bank account and where many governments and governmental agencies also have their accounts, depositing and withdrawing funds like any other customer. The Fed directs the treasury to deposit federal unemployment taxes, withholding taxes, corporate taxes and certain excise taxes. The Reserve Bank issues savings bonds and Treasury securities for the government, and releases funds to pay the government’s bills such as social security and interest on T-bills.

6) The Clearing House

The Fed performs the monumental task of serving as the nation’s check-clearing system, processing over 15 billion checks a year (i.e. 4 1 M checks / daily).

7) The keeper of the gold.

The Money Supply

The Federal Reserve Bank has a strong say in controlling just how much money or buying power is created. It holds the nation’s purse strings. The Fed buys and sells government securities in the open market. The Fed trades to affect the country’s buying power.

When the Fed buys securities, it pumps new money into the system because it allows the banks to add cash to their assets. When the Fed sells securities, it siphons off money from the system, causing banks to deduct cash from their assets.

Definition of Money

Although to most people the term “money” means the bills and coins in their wallets and pockets, in the world of economics, it means more than the cash people carry. To an economist, money includes loans, credit and an assortment of other liquid instruments. Economists divide money into four categories, depending on the type of account in which it is kept.

  1. M1. The most readily available type of money. M1 consists of currency and demand deposits that can be converted to currency immediately. This is the money consumers use for ordinary purchases of goods and services.
  2. M2. In addition to Ml, M2 includes some time deposits that are fairly easy to convert into demand deposits. These time deposits include savings accounts, money market funds and overnight repurchase agreements.
  3. M3. In addition to M1 and M2, M3 includes time deposits of more than $ 100,000 and repurchase agreements with terms longer than one day.
  4. M4 includes M1, M2 and M3 plus other long-term liquid assets, including T-bills, savings bonds, commercial paper, bankers’ acceptance and Eurodollar holdings of U.S. residents.

Most money (M1) that is sorted in the form of demand deposits is checkbook money. M1 is the largest component of the money supply, M2, although smaller in total value, is also of great significance to economists and securities analysts with their eyes on the credit market.

A. How does the Fed increase the money supply?

This is done through the reserve requirement – the amount of money the Fed requires banks to keep in their accounts. If the requirement is 10%, a bank must keep $100 on reserve in the Fed’s vault for every $1,000.00 in its customer deposits. Once this requirement is satisfied, the bank may create $9 for every additional $1 on reserve by providing loans, etc.

This is one way the Fed stimulates the creation of new money. The cycle keeps on going and for every $1,000 of new money released by the Fed, at a reserve level, almost $10,000 of new money will end up in circulation.

B. How does the Fed use the reserve requirement to expand supply?

The Fed buys bonds in the open market.

Types Of Central Bank Intervention

A. Sterilized Intervention

This occurs when the Central Bank offsets its action in the Forex market so that they have no effect on the domestic money supply. This allows authorities to intervene and affect the level of the domestic currency without upsetting other areas of the economy like interest rates. The intervention can affect the exchange rate and market expectations by signaling official intentions about the currency.

Sterilized intervention could take place when the domestic currency is rising and government and Central Banks believe this to be inappropriate. The Central Bank will sell the domestic currency and buy foreign currency. But the Central Bank’s sales of local currency will have added to the domestic money supply, so the Central Bank counters this by selling government securities into the market, thereby draining off funds and offsetting the liquidity of selling the local currency.

B. Non-sterilized intervention

It involves doing nothing to offset the liquidity effects of action in the Forex market. This intervention can have a big impact on the exchange rate because in reality, it is equivalent to monetary policy action.

When   Does Intervention Work?

  1. It is most effective when it pushes a currency the way the market already wants it to go.
  2. It works when it is done as a complement to monetary policy, not a substitute.
  3. It works when changes in foreign currency reserves are allowed to affect domestic interest rates, but not if government offsets their effect by dealing in their own securities market.

Different Central Banks

  1. Federal Reserve Bank (FED) – United States
  2. European Central Bank (ECB) – Euroland
  3. Bank of Japan (BOJ) – Japan
  4. Bank of England (BOE) – United Kingdom
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