Federal Reserve System

LECTURE NOTES

I. THE U.S. BANKING SYSTEM PRIOR TO THE FED

The early history of banking in the U.S. was characterized by frequent and serious difficulties. The First and Second Banks of the United States represented commendable efforts to strengthen banking activity but fell victim to political pressure. The National Banking Act of 1864 was another milestone in legislative attempts to strengthen banking practices. The nation finally came to grips with the need for a central banking system with the creation of the Federal Reserve System in 1913. Among the weaknesses of the banking and monetary system that the Fed was designed to correct was the arrangement for holding reserves and the inflexibility of banks' ability to expand or contract note issues in response to business conditions.

It was common practice for banks to place their reserve funds with other banks. This was especially true of small banks that depended on large city correspondent banks to hold their reserves. Yet, during periods of general economic distress, the large banks were often unable to meet deposit withdrawal requests from their correspondents.

One of the characteristics of an effective monetary system is the ability to increase or decrease the supply of credit as required by changing business conditions. There had been no provision for flexibility in notes issued by banks under terms of the National Banking Act. The Fed corrected these two weaknesses by instituting an effective arrangement for holding the reserves of member banks with their Federal Reserve Bank and by assuming the primary responsibility for notes issued and credit management in general.

The role of a central bank is to lend money to member banks; to hold reserves of member banks; and to influence the cost, availability, and supply of money. In addition, central banks provide many services for members and exercise supervisory and regulatory authority to maintain sound banking practices. The lack of a central banking system in the U.S. for so long in its history was due to an inherent distrust of strong central banks by outlying regions of the country. A compromise to address the critical need for central banking was reached by creating a system of regional central banks.

II. STRUCTURE OF THE FEDERAL RESERVE SYSTEM

The 12 regional Federal Reserve Banks and the Board of Governors of the Federal Reserve System are responsible for the conduct of monetary policy in this country. In addition, many services are provided by the Fed to both the financial community and to businesses. The scope of Fed activities is described fully in a booklet published by the Board of Governors entitled The Federal Reserve System: Purposes and Functions. Copies may be obtained free of charge from Publications Services, Division of Support Services, Board of Governors of the Federal Reserve System, Washington, DC 20551.

III. OVERVIEW OF FEDERAL RESERVE SYSTEM RESPONSIBILITIES

The responsibilities of the Federal Reserve System may be categorized as relating to monetary policy; supervision and regulation; and services provided for depositories institutions, government, and individuals. The Fed's exercise of monetary policy promotes economic stability. It is interesting to note that the Fed's monetary policy activities were not present in 1913 when the Fed was established. This has become basic to its operations because of the increasing need over the years.

Dynamic actions are Fed actions that stimulate or repress the level of prices or economic activity. Defensive activities are Fed activities that offset unexpected monetary developments and contribute to the smooth everyday functioning of the economy. The accommodative function is Fed efforts to meet credit needs of individuals and institutions, clearing checks, and supporting depository institutions.

IV. ROLE OF THE CHAIR OF THE FED BOARD OF GOVERNORS

The chair of the Board of Governors of the Federal Reserve System is generally recognized as the single most powerful influence on monetary policy in the nation. History shows that under the guidance of Paul Volcker (beginning in 1979), a restrictive Fed policy was successful in bringing down the double-digit inflation of the 1970s and the beginning of the 1980s. During Alan Greenspan's service as Chair of the Fed Board (beginning in 1987), there has been real economic growth in the U.S. economy, interest rates declined to historic lows, and stock prices reached all-time highs.

Chapter 4

Federal Reserve System (cont'd)

V. MONETARY POLICY FUNCTIONS AND INSTRUMENTS

The Federal Reserve System's monetary controls are accomplished by influencing the level of bank reserves. It is the reserves of the nation's depositories that determines their willingness and ability to extend loans. Three principal mechanisms are utilized by the Fed in influencing reserve levels--reserve requirements, discount rate policy, open-market operations.

The first, and most important, mechanism is that of open market operations carried out by the Federal Open Market Committee. By purchasing or selling large blocks of obligations (typically U.S. government short-term obligations), funds are placed in or withdrawn from the nation's depositories. The movement of funds is equivalent to the alteration of reserve levels since the Fed makes payments to, and withdraws from, reserve positions. The purchase of securities by the Fed results in an increase in depository reserves, and with it the ability to extend credit. Excess reserves provide no income to the depository; it is natural for depositories, like other enterprises, to utilize their assets in productive ways. On the other hand, withdrawing reserves from depositories reduces their ability and willingness to extend