Your Friend the Federal Reserve

by Dual Income No Kids on January 5, 2008 · 0 comments

Hello All,

Today’s posting is bit of a departure from our usual topics. Today I wanted to say a little bit about the structure of the American banking system. Specifically we talking about America’s national bank: the Federal Reserve.

The Federal Reserve was created by an act of Congress in 1913 in response to a series of banking panics in 1907. After an exhaustive study of European banking systems congress passed the 1913 Federal Reserve Act. The Federal Reserve System now comprises 12 regional federal reserve banks, a board of governors and a federal open market committee (FOMC) – lot of bureaucracy all collectively known as the “Fed”. So, when the news talks about the Fed this bureaucracy is what they’re talking about.

Now, how does the Fed work? Well, first off, it’s quasi-private. That is, the banks involved are for profit entities, but the board of governor’s and the chairman are nominated by the president and confirmed by the senate. – In the case of the board of governors the term of service is 14 years – long enough not to care about politics. However, the core activities of the fed are to supervise and regulate transactions between local banks and manage the nation’s money. The last point is the most interesting. The fed manages the money by doing several things. 1) setting reserve requirements for banks, 2) changing interest rates and 3) buying government securities.

The reserve requirements are less clear, so I’ll say a bit about them. If you are bank, you are required by law to maintain a given percentage of your deposits in reserve. Lets say a bank receives a $100 deposit and has a reserve requirement of 10%. The bank can then lend out $90. That $90 is deposited in another bank, freeing up an additional $81 dollars to be lent. – All of a sudden the initial $100 is turned into $271 in circulation (100+90+81). The amount in circulation changes depending on the reserve requirement. The only problem with changing reserve requirements is that its sometimes a blunt policy tool, but the Fed can also change interest rates or buy government securities, so I’ll just say a bit about those options.

Setting interest rates is pretty simple (clicky), but how buying government bonds impacts the money supply uses a more complicated mechanism so I’ll explain it. Lets say the Fed’s statistics indicate there is a problem with inflation. So, the fed bosses call up their traders in New York and tell them to start buying government bonds. The bonds are purchased and payment is credited to the relevant bank accounts, thus increasing available deposits and allowing the banks to change the amount of money in circulation (more here).

The truth is that the Fed is a complicated decentralized bureaucracy. It also deals in concepts that are non-intuitive. – Most people don’t even think of money in terms of supply and demand. Because of this, its attracted conspiracy theorists, as well as some legitimate criticisms by the likes of Jim Cramer, who argue it lacks transparency and conservative politicians like Ron Paul who are in favor of commodity backed money.

It’s your money, so it makes sense to understand how the government is managing it.

This is a dry posting, I’ll just end it by encouraging you to enjoy a little Federal Reserve humor. (Funny video!)



Get Your FREE Ebook


DINKS (Dual Income No Kids) Finance focuses on personal finance for couples. While by no means financial experts, we strive to provide readers with new, innovative ways of thinking about finance. Sign up now to get our ebook, "Making Money Tips for Couples" FREE.

We won't send you spam. Unsubscribe at any time. Powered by ConvertKit

{ 0 comments… add one now }

Leave a Comment

Previous post:

Next post: