ECN 202

Connor Fannon

Federal Reserve Paper

Connor Fannon
The Federal Reserve
Structure and Function of the Federal Reserve (FED)
The Federal Reserve, otherwise known as the FED, is the central bank of the United
States. It is in charge of stabilizing our economy and regulating our nations financial
institutions. It was first created in 1913 after a financial crisis occurred called The 1907
Bankers Panic. The New York Stock Exchange fell almost 50% from its peak the previous year
so everybody was trying to withdraw their money. Since the banks had issued loans prior to the
fall of the New York Stock Exchange crash, they did not have enough money in the system to
fulfill everybodys withdraws. This situation is what caused the Federal Reserve Act to be
created, and with that, the Federal Reserve. The Federal Reserve Act was created by the
Congress to provide the nation with a safer, more flexible, and more stable monetary and
financial system. The Federal Reserve was created on December 23, 1913, when President
Woodrow Wilson signed the Federal Reserve Act into law. Today, the Federal Reserve's
responsibilities fall into four general areas.

Conducting the nation's monetary policy by influencing money and credit conditions in
the economy in pursuit of full employment and stable prices.

Supervising and regulating banks and other important financial institutions to ensure the
safety and soundness of the nation's banking and financial system and to protect the
credit rights of consumers.

Maintaining the stability of the financial system and containing systemic risk that may
arise in financial markets.

Providing certain financial services to the U.S. government, U.S. financial institutions,
and foreign official institutions, and playing a major role in operating and overseeing the
nation's payments systems.
(Current FAQs)

The FED is comprised of a complex structure that includes the Board of Governors,
Federal Reserve Banks, Federal Open Market Committee, Member Banks, and Advisory
Committees. Each of these branches are in charge of monitoring the health of the economy by
adopting various economic policies. One of the most important of which is monetary policies
that supports long run health of the economy, meaning it regulates sustainable employment and
stable prices on goods and services.

Fannon 2

The above picture describes structure of the FED.

Board of Governors
The Board of Governors is a Federal Reserve agency and is comprised of a group of 7
individuals appointed by the president. These 7 individuals are responsible for monitoring the
entire Federal Reserve System. The Board of Governors has about 1,850 employees. The
Board plays a key role in the decisions of the Federal Open Market Committee (FOMC). The
members of the Board of Governors have a majority (7 out of 12) of the votes on the FOMC, the
arm of the Fed that determines the nation's monetary policy. The five other votes belong to the
president of the Federal Reserve Bank of New Yorkit is the New York Fed that conducts the
open market operations to implement the FOMC's monetary policyand four other Reserve
Bank presidents who serve one-year terms as voting members of the FOMC on a rotating basis.
The chairman of the Board of Governors serves as chairman of the FOMC. (Board of
Governors)
Another responsibility the Board has is monitoring banking deposits. The Board has the
authority to set a reserve requirement of from 8 percent to 14 percent on transaction deposits
(deposits in checking and other accounts from which transfers can be made to third parties) and

of up to 9 percent on non-personal time deposits (deposits not held by an individual or sole

proprietorship). Adopting monetary policies such as the reserve requirement ensures there is
Fannon 3
some money that can be loaned to consumers to spend, rather than all being stored in to their
reserves where nobody can touch it or spend it.
One more important thing the Board is in charge of doing is approving the discount rate.
This is the interest rate charged to commercial banks and other depository institutions on loans
they receive from their regional Federal Reserve Bank's lending facility--the discount window.
Federal Reserve Banks
The main purpose for the Federal Reserve Banks are to flow currency in and out of
circulation. This helps keep the economy healthy. They also collect and process millions of
checks every day. Many of the services provided by this network to depository institutions and
the government are similar to services provided by banks and thrift institutions to business
customers and individuals. Reserve Banks hold the cash reserves of depository institutions and
make loans to them. (Federal Reserve System) The Federal Reserve Banks also have checking
account issued to the U.S. treasury and issue/redeem government securities. (Federal Reserve
System) Reserve Banks have specified requirements in which they must keep a certain
percentage of deposits in their vaults. The FOMC is in charge of deciding what this percentage
will be and they use this as a way to put money and take money out of circulation within the
economy. The FED uses this as a way to keep the economy stable and avoid booms and
recessions. Taking money out of circulation will avoid enormous booms in the economy and
putting more money in will avoid recessions.
Federal Open Market Committee
The Federal open market committee (FOMC) is a branch of the Federal Reserve Board
that is mainly in charge of the monetary policies that they put in motion. The FOMC is made up
of the 7 members of the board of governors plus an additional 5 people who are the 5 reserve
bank presidents. The policies that are decided by the FOMC all are to promote stable prices and
economic growth. The Federal Reserve System are also responsible for formulating policies that
affect the discount rate and reserve requirements, which will be further discussed later in the
document.
Member Banks
National banks chartered by the federal government are, by law, members of the Federal
Reserve System. State-chartered banks may choose to become members of the Federal Reserve
System if they meet the standards set by the Board of Governors. (Econ D) From a customers
point of view, being a member at a member bank means there will be many different branch
locations, where as if you chose to be a member at a non-member bank there will likely be much
less branch locations. Member banks are different than non-member banks because they hold

Federal Reserve stock, which is not like normal publicly traded stock. National banks chartered
by the federal government are, by law, members of the Federal Reserve System. State-chartered
banks may choose to become members of the Federal Reserve System if they meet the standards
Fannon 4
set by the Board of Governors. Each member bank is required to subscribe to stock in its regional
Federal Reserve Bank, but holding Federal Reserve stock is not like holding publicly traded
stock. Reserve Bank stock cannot be sold, traded, or pledged as collateral for loans. As specified
by law, member banks receive a six percent annual dividend on their Federal Reserve Bank
stock; member banks also vote for Class A and Class B directors of the Reserve Bank. (Perry)
Advisory Committees
The advisory committee is in charge of advising the board of governors and guiding
them in their decision making. There are 3 committees that advise the board of governors for
different responsibilities.
Federal Advisory Council.
This council, which is composed of twelve representatives of the banking industry,
consults with and advises the Board on all matters within the Board's jurisdiction.
Consumer Advisory Council.
This council, established in 1976, advises the Board on the exercise of its responsibilities
under the Consumer Credit Protection Act and on other matters in the area of consumer financial
services. The council's membership represents the interests of consumers, communities, and the
financial services industry. Members are appointed by the Board of Governors and serve
staggered three- year terms.
Thrift Institutions Advisory Council.
The Board of Governors established this council to obtain information and views on the special
needs and problems of thrift institutions. Unlike the Federal Advisory Council and the Consumer
Advisory Council, the Thrift Institutions Advisory Council is not a statutorily mandated body,
but it performs a comparable function in providing firsthand advice from representatives of
institutions that have an important relationship with the Federal Reserve.
(Federal Reserve System)
Goals of Fed Policy
In conducting the Federal Reserve Act, Congress specified the universal objectives for
monetary policy. These objectives include maximum employment, stable prices, and moderate
long-term interest rates. The Federal Open Market Committee (FOMC) is firmly committed to

fulfilling this statutory mandate. In pursuing these objectives, the FOMC seeks to explain its
monetary policy decisions to the public as clearly as possible. Clarity in policy communications
facilitates well-informed decision making by households and businesses, reduces economic and
Fannon 5
financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency
and accountability, which are essential in a democratic society.
When evaluating stable prices, the FOMC keeps a close eye on inflation to ensure prices
will not fluctuate. The FOMC judges that inflation at the rate of 2 percent (as measured by the
annual change in the price index for personal consumption expenditures, or PCE) is most
consistent over the longer run with the Federal Reserve's statutory mandate. Communicating this
inflation goal clearly helps keep longer-term inflation expectations firmly anchored, thereby
fostering price stability and moderate long-term interest rates and enhancing the FOMC's ability
to promote maximum employment. (Federal Reserve) This monetary strategy promotes a
healthy economy because the lower interest rates not fluctuating persuades buyers to keep
pumping money back in to the businesses, thus keeping supply and demand at its maximum.
When Supply and demand is at its maximum it persuades businesses to employ more. They need
many more workers to meet the demands of the people.
The FOMC does not have a standard goal pertaining to maximum employment. Because
employment situations are largely influenced by non-monitory factors, they must put forth
policys based merely upon projections, otherwise known as member assessments. The
FOMC's policy decisions must be informed by its members' assessments of the maximum level
of employment, though such assessments are necessarily uncertain and subject to revision. In the
FOMCs September 2015 Summary of Economic Projections, Committee participants estimates
of the longer-run normal rate of unemployment ranged from 4.7 to 5.8 percent and had a median
value of 4.9 percent.
In setting monetary policy, the Committee looks for deviations of inflation from its long
run goal and also deviations of the maximum level of employment from the member
assessments. These two factors normally compliment one another nicely. However, under
circumstances in which the Committee judges that the objectives are not complementary, it
follows a balanced approach in promoting them, taking into account the magnitude of the
deviations and the potentially different time horizons over which employment and inflation are
projected to return to levels judged consistent with its mandate. These deviatons of inflation
and employment can be due to many different things so the Committee pays close attention to
any possible factor and then puts forth various policies to regulate that factor.
This section found at: (Federal Reserve)
Tools of the FED
The Federal Reserves three instruments of monetary policy are open market operations, the
discount rate and reserve requirements.

Fannon 6
Open Market Operations
Open Market Operations is essentially the business of purchasing government bonds.
Because there is no government involved with an open market, the prices of goods and services
are created by supply and demand of currency, and not because of cartels or government policy.
Open market operations involve the buying and selling of government securities. The term
open market means that the Fed doesnt decide on its own which securities dealers it will do
business with on a particular day. Rather, the choice emerges from an open market in which
the various securities dealers that the Fed does business with the primary dealers compete on
the basis of price. (Open Market Operations) In this tool of the FED, there are no monetary
policies put in place, regarding set prices in the market. The FED is able to adjust the level of
reserve balances in the banking system through open market operations which then in turn
affects the prices. This is the way the Fed can offset or support permanent, seasonal or cyclical
shifts in the supply of reserve balances and affect short-term interest rates and by extension other
interest rates to reach monetary goals for a specified period of time. Because this tool of the FED
is easy and flexible, it is the most used tool.
The FOMC is in charge of implementing monetary policies and deciding what route our
economy should take. If the FOMC wants to increase the money supply in the economy it will
buy these securities from the banks. The money the banks receive from this sale can be used to
loan out to people and businesses, thus putting more money back in to the economy. The more
money that is available in the market for lending, the lower the interest rates on these loans
become, which causes more borrowers to access cheaper capital. This easier access to capital
leads to greater investment and will often create a more healthy economy.
If the FOMC wants to decrease the money supply it will sell the securities back to the
banks, essentially taking money from the banks and putting it in the reserves. The decrease in
money available in the economy leads to a decrease in investment and spending because the
availability of capital decreases and it becomes more expensive to obtain because of interest
rates. This limiting of access to capital slows down economic growth as investment decreases.
The FOMC would use this approach if GDP was raising dangerously fast and they wanted to
bring it down to normal levels to avoid a potential recession.
The Discount Rate
The discount rate is the interest rate charged to commercial banks and other depository
institutions on loans they receive from their regional Federal Reserve Bank's lending facility--the
discount window. The Federal Reserve Banks offer three discount window programs to
depository institutions: primary credit, secondary credit, and seasonal credit, each with its own
interest rate. All discount window loans are fully secured.
Under the primary credit program, loans are extended for a very short term (usually
overnight) to depository institutions in generally sound financial condition. Depository
institutions that are not eligible for primary credit may apply for secondary credit to meet short-

term liquidity needs or to resolve severe financial difficulties. Seasonal credit is extended to
relatively small depository institutions that have recurring intra-year fluctuations in funding
needs, such as banks in agricultural or seasonal resort communities.

Fannon 7
The discount rate charged for primary credit (the primary credit rate) is set above the
usual level of short-term market interest rates. (Because primary credit is the Federal Reserve's
main discount window program, the Federal Reserve at times uses the term "discount rate" to
mean the primary credit rate.) The discount rate on secondary credit is above the rate on primary
credit. The discount rate for seasonal credit is an average of selected market rates. Discount rates
are established by each Reserve Bank's board of directors, subject to the review and
determination of the Board of Governors of the Federal Reserve System. The discount rates for
the three lending programs are the same across all Reserve Banks except on days around a
change in the rate.
(Federal Reserve)
Reserve Requirements
Because of the Bankers Scare of 1907, Congress created reserve requirements, meaning
banks must keep portions of deposits in their vaults or on deposit at the Federal Reserve Bank.
These reserve requirements play a very important role in the Federal Reserves primary tool,
open market operations. In the early 1980s, for example, when open market operations were
geared toward fostering fairly precise, short-run control of narrowly defined money (M1),
reserve requirements were designed to help facilitate this control by establishing a relatively
stable, contemporaneous link between reserves and M1 deposits. Although the Federal Reserve
is no longer pursuing this type of short-run control of money, reserve requirements still play an
important role in the conduct of open market operations, which are now aimed at influencing
general monetary and credit conditions by varying the cost and availability of reserves to the
banking system. By helping to ensure a stable, predictable demand for reserves, reserve
requirements better enable the Federal Reserve to achieve desired reserve market conditions by
controlling the supply of reserves; in so doing, they help prevent potentially disruptive
fluctuations in the money market. Without reserve requirements there would be a chance of
shortage of funds in recession or depression situations, just like there had been in the Bankers
scare of 1907.
One of the major tools the Federal Reserve Banks uses to keep a good flow of currency is
through Fractional Reserve Banking. Fractional Reserve Banking is a system of accepting
deposits and lending that deposit out to other people or institutions. The Federal Reserve Banks
take a fraction of whatever you deposit at the bank for their vault storage, then lends your money
to other people, which essentially is creating more money. The Federal Reserve Explains it this
way: The fact that banks are required to keep on hand only a fraction of funds deposited with

them is a function of the banking business. Banks borrow funds from their depositors (those
with savings) and in turn lend those funds to the banks borrowers (Those in need of funds).
Banks make money by charging borrowers more for a loan (a higher percentage interest rate)
then is paid to depositors for use of their money. If banks did not lend out their available funds
Fannon 8
after meeting their reserve requirements, depositors might have to pay banks to provide
safekeeping services for their money. For the economy and the banking system as a whole, the
practice of keeping only a fraction of deposits on hand has an important cumulative effect.
Referred to as the fractional reserve system, it permits the banking system to create money.
When you go and deposit money in the bank, there is a specified percentage of money the
bank is required to put in its reserves, it then can lend whatever is not in that reserve out to
somebody else. For instance, if you deposit $100,000 at the bank and the bank has a reserve
requirement of 10 percent, the bank must keep $10,000 of your money on reserve and can lend
out the $90,000. Essentially the bank has taken $100,000 and has turned it into $190,000 by
giving you a $100,000 credit on your deposits and then lending the additional $90,000 out to
someone else.
Now, if you take this out a little further, you will see that your original $100,000 can
become more money by the time it is all over. Heres how:

You deposit
That person deposits
That person deposits
That person deposits
That person deposits
That person deposits
That person deposits

$100,000
$90,000
$81,000
$72,900
$65,610
$59,049
$53,144

Your bank loans someone else

Their bank loans someone else
Their bank loans someone else
Their bank loans someone else
Their bank loans someone else
Their bank loans someone else
Their bank loans someone else

$90,000
$81,000
$72,900
$65,610
$59,049
$53,144
$47,829

And so on
Ultimately, your initial $100,000 can grow into $1,000,000 with a 10 percent reserve
requirement. To find out exactly how much money the fractional reserve banking system can
theoretically create with your initial deposit, you can use the Money Multiplier equation:
Total Money Created = Initial Deposit x (1 / Reserve Requirement)
For example, with the numbers we have used above, you equation would look like this:
$1,000,000 = $100,000 x (1 / 0.10)

(Understanding Markets)

Fannon 10
New Federal Reserve Goal
One of the most recent goals of the Federal Reserve is putting an end to the stimulus
package around the middle of this year. The package stimulated substantial job growth since the
recession and lowered unemployment lower than 6%. Through September, employers added
227,000 jobs a month so officials are confident that putting an end to the stimulus package wont
devastate the economy.
The decision, expected at the end of a two-day meeting of the Feds policy-making
committee, would cap a six-year period during which the central bank has expanded its holdings
of Treasury and mortgage-backed securities to almost $4.5 trillion, from less than $1 trillion in
mid-2008. To ensure the economy will remain stable after the stimulus package is put to an end,
the FOMC will likely lower interest rates by buying government bonds from the bank. This is
the most common way the FOMC likes to lower these rates. Lowering the interest rate will
make the buyers believe that putting an end to the stimulus package will not hurt the economy at
this point. The economy is ready to be on its own again.
Interest Rates
The interest rate is the proportion of a loan that is charged as interest to the borrower,
typically expressed as an annual percentage of the loan outstanding. The FED uses interest rates
to affect the supply of available funds. Raising the rate makes it more expensive to borrow
because it lowers the supply of available money, which increases the short-term interest rates and
helps keep inflation in check. Lowering the rate has the opposite effect, bringing short-term
interest rates down.
The 3 tools of the FED directly influence interest rates. Open Market Operations
influence interest rates because they directly influence the amount of funds in reserves, thereby
either increasing money supply or decreasing money supply. When money supply increases, it
would lower the interest rate because there is more money readily available. When Open Market
Operations lower the money supply, it would drive up interest rates because money is not as
available, so it makes it more expensive to withdraw. Open Market Operations generally affect
interest rates in the short term rather than the long term.
The Discount rate is in some ways an alternate to open market operations. The FED uses
discount rates to raise and lower the monetary base. A high discount rate would reduce
borrowing, thus leaving more money in the reserves and out of the economy. A low would do
the opposite, increase borrowing, thus putting more money out in the economy. This would have
the same affect on interest rates as Open Market Operations, but the relationship between
discount rates and interest rates though, are normally much more complicated than this. For the
discount rate to have any affect on the interest rate you would need to put in consideration three

things, the demand for credit at that given time, the supply of credit at that given time, and also
the market clearing conditions. All of these conditions fluctuate and can have a direct impact on

Fannon 11
interest rates. This is why the FED does not only rely on discount rates to carry out its monetary
policies and goals.
Reserve Requirements are one of the most important influences on an interest rate. The
FEDs Board of Governors is allowed to set any reserve requirement on banks. The reserve
requirement directly influences the willingness to give out or call back in loans, which then
affects the money supply and affects interest rates. Lowering the reserve requirement increases
the bankers availability of funds to make more leans, thus tending to expand the money stock
and (in the short run at least) to lower interest rates and encourage both consumers and investors
to buy more. Raising the reserve requirement restricts the bankers ability to make more loans,
and those banks that were already operating just barely above the old reserve requirement will
probably be forced to call in some of their existing loans to meet the tougher new requirement,
thus tending to shrink the money stock, raise interest rates, and thus reduce the volume of
purchasing on credit in the economy as a whole.

Fannon 12
Works Cited
Appelbaum, B. (2014, October 29). Fed Plans Next Phase as End to Stimulus
Program Is Expected. Retrieved October 15, 2015, from
http://www.nytimes.com/2014/10/30/business/federal-reserve-plans-next-phaseas-end-to-stimulus-program-is-expected.html?_r=0
Balasubramaniam, K. (2006, August 29). How do open market operations affect
the U.S. money supply? Retrieved October 14, 2015, from
http://www.investopedia.com/ask/answers/06/openmarketoperations.asp
Board of the Governors of the Federal Reserve System. (2008, November 1).
Retrieved October 14, 2015, from
http://www.newyorkfed.org/aboutthefed/fedpoint/fed46.html
Current FAQsInforming the public about the Federal Reserve. (2014, February 4).
Retrieved October 14, 2015, from
http://www.federalreserve.gov/faqs/about_12594.htm
Daniel L., T. (n.d.). The Discount Rate and Market Interest Rates: Whats the
Connection? Retrieved October 14, 2015, from
https://research.stlouisfed.org/publications/review/82/06/Discount_Jun_Jul1982.p
df
Econ, D. (n.d.). Why did the Federal Reserve start paying interest on reserve
balances held on deposit at the Fed? Does the Fed pay interest on required
reserves, excess reserves, or both? What interest rate does the Fed pay?
Retrieved October 14, 2015, from
http://www.frbsf.org/education/publications/doctor-econ/2013/march/federalreserve-interest-balances-reserves
FRB: The Federal Reserve System Purposes and Functions. (2013, April 24).
Retrieved October 14, 2015, from http://www.federalreserve.gov/pf/pf.htm

Federal Reserve System. (n.d.). Retrieved October 14, 2015, from

https://www.richmondfed.org/faqs/frs
Federal Reserve System. (n.d.). Retrieved October 14, 2015, from
http://www.federalreserve.gov/pf/pdf/pf_1.pdf#page=4
Johnson, P. (n.d.). A Glossary of Political Economy Terms. Retrieved October 14,
2015, from https://www.auburn.edu/~johnspm/gloss/reserve_requirement
Johnson, P. (n.d.). A Glossary of Political Economy Terms. Retrieved October 14,
2015, from https://www.auburn.edu/~johnspm/gloss/reserve_requirement
Marotta, D. (2014, May 10). The Purpose Of The Federal Reserve. Retrieved
October 14, 2015, from http://www.forbes.com/sites/davidmarotta/2014/05/10/thepurpose-of-the-federal-reserve/
Open Market Operations. (2007, August 1). Retrieved October 14, 2015, from
http://www.newyorkfed.org/aboutthefed/fedpoint/fed32.html
Perry, R. (1999, September 1). The Role of the Federal Reserve in the Economy.
Retrieved October 14, 2015, from http://www.frbsf.org/files/990921.pdf
Reserve Requirements: History, Current Practice, and Potential Reform. (n.d.).
Retrieved October 14, 2015, from
http://www.federalreserve.gov/monetarypolicy/0693lead.pdf
The Structure of the Federal Reserve System - Federal Reserve Education. (n.d.).
Retrieved October 14, 2015, from https://www.federalreserveeducation.org/aboutthe-fed/structure-and-functions
Understanding the Fractional Reserve Banking System. (n.d.). Retrieved October
15, 2015, from http://www.learningmarkets.com/understanding-the-fractionalreserve-banking-system/