The beginning of the Federal Reserve
System as well as its development can be seen through the eyes of a developing
country, the United States of America. Between the years 1775-1791, the Continental
Congress printed what was called, Continentals, the first paper money, this was
issued to help finance the American Revolution, its use led to a quick rise in
inflation and along with the need for an effective monetary controls at banking.
(HFR)
By 1791-1811, at the request of the
current Treasury Secretary, Alexander Hamilton, Congress established the First
Bank of the United States, headquarter in Philadelphia. The bank was created in
1791 and given a 20-year charter. At the time, it became the largest corporation
in the United States and was controlled by big business and money interests. “When
the charter expired in 1811, Congress was unable to renew it and the charter
was defeated by just one vote” (HFR).
By 1816, the idea of a Central Bank
was once again popular and Congress created the Second Bank of the United States
giving it another 20-year charter. However, in 1928, Andrew Jackson was elected
President and as a banking foe, his continued attacks led to its failure to
renew its charter and it expired in 1936. By 1836, After the expiration of the
second charter bank there was a period called, The Free Banking era which saw
the increase of check transactions. This was a growth period for state
chartered banks and uncharted free banks. In response, the New York
clearinghouse association was created in 1853, to regulate the flow of check
transactions.
In 1863, the country was deeply
involved in the Civil war, and the National Banking act of 1863 was created to control
nationally chartered banks, thus providing a mechanism for the backing of American
circulating notes. All notes had to be backed by US government securities, and state
bank notes were also subject to taxation, but not national bank notes. Even so
the state banks prospered mostly due to the growing popularity of demand
deposits.
The National Banking act provided
some stability however as the bank runs and financial panic led to a disastrous
situation. By 1893 this created a banking panic that triggered the worst crisis
to date. “It took the deep pockets of the Americas richest private citizen, JP
Morgan to help save the country and the banking industry.” (HFR)
By the year 1907, privateers created
another dangerous situation and once again the mogul, JP Morgan was called into
save the county. In response to the crisis of 1907, the Aldrich Vreeland act of
1908 was passed as an immediate response to help provide a system to issue
currency during a crisis. The Aldrich act also created the national monetary
commission to help search for a long term solution. However, as this was a system controlled by
the banks, the election of 1912 brought to power a long time stalwart of
banking, the Democrat Woodrow Wilson. President Wilson killed the Republican
controlled Aldrich plan. But the calls for a decentralized bank continued.
The Democrat Woodrow Wilson was quick
to seek advice from Virginia representative Carter Glass, who would later
become the Chairman of the House Committee on Banking and Finance. President
Wilson was also getting advice from, H. Parker Willis formerly a professor of
economics at Washington and Lee University. “By December 1912, Glass and Willis
were able to provide the President with what was to become, after a few changes
the basis for the Federal Reserve Act.” (OFRS)
The Glass-Willis proposal for the Federal
Reserve System was debated and rewritten from December 1912 to December 1913, and
on December 23, 1913 the act was turned into law when President Woodrow Wilson
signed the Federal Reserve Act. The Federal Reserve act stood as an example of
compromise between private banks and populist sentiment. Thus the Federal Reserve
was established in 1913, but the reserve bank operating committee still had to choose
the cities to open the branches in, which was finally established by November
16, 1914.
The structure of the Federal Reserve,
number of branches and its headquarters was next on the list to establishing a
coordinated banking system. The primary responsibility of the Federal Reserve
system is to formulate monetary policy. The Federal Reserve chose 12 cities in
Nov. 1914, as cites for its regional banks. The cities chosen were: Boston, NY,
Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis,
Kansas City, Dallas and San Francisco.
Washington DC was named as the headquarters for its board of governors. (OFRS)
The full network is comprised of the
12 Federal reserve banks and their branches. The 25 different branches are the
following: Buffalo, Cincinnati, Little Rock, Louisville, Memphis, Helena,
Denver, Oklahoma City, Omaha, El Paso, Houston, San Antonio, Los Angeles,
Portland, Salt Lake City and Seattle. The distribution is based on size of city
and the economic needs of its communities.
The Seven members of the Board of Governors
are appointed by the President and confirmed by the Senate to serve a 14-year
term of office. Members may only serve one full term of office. “The President
designates and the Senate confirms both a Chairman and a Vice Chairman for a 4-year
term.” (SFRS)
The Board of Governors has broad
oversight and responsibility for the operations and oversight of the Federal
Reserve banks. “Each Federal Reserve Bank must submit its annual budget to the
Board of Governors for approval. Particular types of expenditures—such as those
for construction or major alterations of Reserve Bank buildings and for the
salaries of Reserve bank presidents and first vice presidents –also are subject
to specific Board approval.” (OFRS)
A major component of the system is
the federal open market committee(FOMC), which is made up of the members of the
Board of Governors, the President of the Federal Reserve Bank of New York and
Presidents of four other federal reserve banks, who serve on a rotating basis(OFRS).
The main purpose of the Federal
Reserve Policy is to control economic activities. There are three main kinds of
monetary policy each one having a unique effect on GDP, unemployment and
inflation. “For the most part, the demand for goods and services is not related
to the market interest rates quoted in the financial pages of newspapers, known
as nominal rates-that is, nominal interest rates minus the expected rate of
inflation.” (FRBSF)
Open market operations(OMO), the
purchase and sale of securities in the open market is a key tool used by the
federal reserve in controlling monetary policy.
“In the long run, output and
employment cannot be set by monetary policy. In other words, while there is a
tradeoff between higher inflation and lower employment, in the short run, the
trade-off disappears in the long run.” (FRBSF)
There are two types of OMOs,
permanent and temporary. Permanent Omos involve the outright purchase or sales
of securities driving the expansion of the federal reserve balanced sheet.
Permanent Omos primarily involve the growth of currency in circulation.
Temporary Omos are used to address reserve needs that are deemed transitory in
nature. These needs are either repurchasing agreements or reverse repurchase
agreements. Under a repo, the trading desk buys a security under an agreement
to resell the security in the future. A repo is the economic equivalent of a collateralize
loan in which the difference between the purchase and sale prices reflect
interest.
“Before conducting open market
operations, the staff at the Federal Reserve Banks of NY collects and analyzes
data and talks to banks and others to estimate the amount of bank reserves to
be added or drained that day.” (MPB)
The Federal Fund rate is the interest
rate that depository institutions actively trade balances held at the federal reserve
called federal funds with each other. In other words, it’s the rate that
commercial banks charge each other to borrow money, usually overnight. The
money they are borrowing is called federal funds. This affects inflation, “when
the federal funds rate is reduced, the resulting stronger demand for goods and
services tends to push wages and other costs higher, reflecting the greater
demand for workers and materials that are necessary for production.” (FRB2).
“All discount window loans are fully secured” (FRBDR)
The effects of GDP targeting can be
both stabilizing and destabilizing. “Would the Fed reduce systematic
(undiversifiable) risk in the economy by stabilizing nominal GDP if doing so
raises uncertainty about future inflation and the price level” (MPTR). This is
a fundamental issue which, “complicates decisions for households and firms who
must distinguish relative price changes from inflation surprises in order to
make efficient choices.” (MPTR)
Federal funds are funds deposited
with the Federal Reserve by Commercial banks. “The federal funds include money
that is in excess of bank reserves(FFR).
Banks can transfer money from federal
funds among themselves and be subject to the federal fund rate or make a
transfer from the feds to themselves on behalf of bank customers on a same day
basis, which is called the discount window. Most of these transfers are just on
paper, no physical money usually changes hands(FFR). The federal fund rate is
determined by the balance of supply and demand for the funds. The actual rate
fluctuates and is set by the FOMC (federal open market committee). The rate is
determined by demand for funds as well as the supply by banks for these funds.
The interest charged on these loans is called the discount rate, not the
Federal Fund rate. “When the trend rate of real economic growth rises or falls,
the implicit inflation objective also changes (in the opposite direction).” (MPTR)
The discount rate is the interest
rate charged to commercial institutions on loans they receive from their
regional federal reserve banks lending facility-the discount window(FRB). There
are three main types of discount window programs depending on the health of the
bank. The primary credit is usually for generally sound banks overnight. For
longer terms loans or for banks that are not in as good health, there is the
secondary credit loan. This loan is for a longer term and is priced above the
rate set for primary credit. The third type is a seasonal credit loan which is
used for banks involved in agriculture or seasonal operations (hotels,
resorts). The lower the rate, the easier it is for banks and therefore
consumers to borrow money. The effect of discount rates is to reduce
unemployment and to help decrease inflation.
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