The Federal Reserve System. How it operates, its future role in monetary policy.

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The Federal Reserve System
The Federal Reserve System is the Central Bank of the U. S. whose job is to oversee three functions: monetary policy; supervision and regulation of banks, and payment systems. The system is made up of three components: the Board of Governors; 12 Federal Reserve Banks, and member banks.
The Federal Reserve was formed in 1913 when the Federal Reserve Act was passed in the Senate after a series of failures in banks created the urgent need for a central bank to create an autonomous and healthy banking system in the country. The Board of Governors is the most important decision-making body in the Fed. The seven-member body is appointed by the president and approved by the Senate. It supervises the activities of the Fed and determines how the economy can be stabilized. Each board member serves a 14-year term of office. The terms are staggered such that a new board member is brought in every two years. The Fed chairman serves a four-year term. The Federal Open Market Committee (FOMC) is also at the national level. The FOMC supervises the implementation of the ‘open market operations. The FOMC comprises of the Board of Governors, New York Federal Reserve Bank President, and four Fed Bank presidents. At the district level, the Fed is made of 12 district Federal Reserve banks and 25 branches. The 12 district Fed banks serve a geographic region in the nation. They help stabilize the banking system and offer financial services to the federal government.

For instance, help a commercial bank to clear checks electronically, and extend short-term loans to commercial banks – ensure currency elasticity. The Fed banks also monitor loans and investments made and ensure that commercial banks practice sound banking. Finally, they issue currency and hold cash reserves of the member banks. There are thousands of local member banks in the Fed system. Commercial banks chartered by the federal government must join the Fed. State-chartered banks are on the other hand allowed to choose whether or not to join the Fed system. However, all banking institutions – fed chartered on not – must hold their cash reserves with their district Fed bank. This is necessary to allow the Federal System to intervene promptly in case the system faces a financial crisis in t (O’Connor and Faille 166).
The most essential job of the Fed is to regulate the amount of money in circulation – money supply. Monetary policy constitutes the decisions made by policy makers concerning money supply. The FOMC is in charge of making monetary policy. Its members meet on a six weekly basis in Washington D.C. to consider and make changes in monetary policy. Through the FOMC, the Fed can increase or decrease the amount of dollars circulating in the economy. The Fed uses three tools in monetary policy: reserve requirements open-market operations and the discount rate.
The basic tool in monetary policy is open market operations – the trading of government bonds. When the economy requires an increase in money supply, bond traders at the New York Fed are instructed to buy bonds in the nation’s bond markets. Some of the new dollars paid by the Fed serve as new currency while others are deposited in banks. Each dollar in circulation raises the money supply by $1, while each dollar in a bank account raises the money supply more because it multiplies the reserves by several factors – money multiplier. In effect, banks reduce lending rates, and this reverses the money creation process (Mankiw 620).
A reserve requirement is the minimum reserves banks are must hold each time a deposit is made. They affect how much money the banking system can produce with every each in the reserves. A high reserve requirement means banks must hold more reserves and loan out less of every dollar deposited. This raises the reserve ratio and lowers the money multiplier; reducing the money supply. A decrease in reserve requirements lowers the reserve ratio and raises the money multiplier; increasing the money supply.
Examples:
Deposit Reserve Requirement Money Multiplier Potential Money Creation
$100 10% 10 1000
$100 20% 5 500
$100 25% 4 400
Money multiplier = 1/Reserve requirement
Potential money creation = Deposit × Money multiplier
A discount rate can be defined as the interest rates made to banks. A bank may experience a decrease in reserves when it has too many loans or experienced a lot of withdrawals. The Fed loans the bank money to raise its reserves and create more money. The Federal System may influence the money supply by altering the discount rates. A high-interest rate will keep banks away from borrowing from the Federal Banks. Low reserves of the banks will reduce the money supply. A low-interest rate will mean more borrowing and more money supply. The Fed can also use discount lending to help financial institutions facing difficulties. For instance, in 1987, it gave Wall Street brokerage firms loans to prevent the stock market from crashing.
The supervision and regulation of banking institutions ensure the safety of the institution and financial system and protection of the credit rights of the consumer. It works together with other state authorities to make sure that banking institutions manage their operations safely. The Feds have bank examiners who study financial trends and use the information to make changes in the banking institutions. The supervision and regulation have two main areas of focus: the safety of banks and consumer protection law compliance. A bank examiner measures the safety of a bank by reviewing how it is managed and if its financial condition is favorable. They also check if it complies with the regulations. Safety and soundness are examined using the CAMELS rating system. The letters stand for; capital adequacy, asset quality, management, earnings, liquidity and sensitivity to risk in the market CITATION Fed15 l 2057 (Federal Service Education). The bank’s ability to collect money from loanees and meet its depositors’ claims – risk – is also measured. The lending activity of the bank is reviewed by sampling loans made by the bank and rating its quality. The quality of a loan applicant is normally assessed using the 5-Cs, which stand for; capacity, collateral, condition, capital and character. Other bank regulators include The Office of the Comptroller of the Currency (OCC),), the Office of Thrift Supervision (OTS), and the Federal Deposit Insurance Corporation (FDIC (Federal Service Education).
The Reserve System regulates the payment system – distribute cash, process checks, credits and electronic payments. Fed banks keep money supply in check by: regulating the amount of money circulating in the economy; operating electronic payment systems, providing avenues to process checks, and servicing the government financially. The U.S. Bureau of Engraving and Printing in Washington, D.C., and Fort Worth, Texas is responsible for printing Federal Reserve notes while the U.S. Mints in Philadelphia and Denver produce coins. The currency and coins are then shipped to Fed banks across the country. When financial institutions deposit excess reserves with their Fed banks, they are sorted and verified. Reusable currency and coins are stored in vaults while worn out notes are destroyed. The Secret Service receive the counterfeits. The Federal Reserve processes about 30% of the papers that eventually clear as checks. The Automated Clearinghouse (ACH) payment system offers electronic means of payment. The Federal Reserve processes 25% of the ACH payments (Federal Bank of San Francisco). The Fed wire provides an instant computerized system of making larger transactions between financial institutions. As the U.S. government banker, the Federal Reserve oversees government transactions.
The Federal Reserve faces several challenges in controlling the money supply. Most of these problems are because the money supply is created by the system of fractional-reserve banking. The Fed cannot control the amount of money depositors choose to deposit in banks. Suppose, in future, people lose confidence in the banking system and make withdrawals; the banks will lose their reserves and reduce money supply even without any action by the Fed. The Fed also cannot control how much money banks give to their loan applicants. It cannot estimate how much money the banking institutions will make if banks keep hold of excess reserves instead of giving loans. For instance, if a bank chooses to withhold loans because it is skeptical about the economic conditions, less money will be created and cause a fall in supply. The Fed, therefore, needs to be more vigilant by frequently collecting data on bank deposits and reserves to avoid such problems in future.

Works Cited
BIBLIOGRAPHY Federal Bank of San Francisco. What is the Fed: Payment Services. 2015. 1 December 2015 <http://www.frbsf.org/education/teacher-resources/what-is-the-fed/payment-services>.
Federal Service Education. Banking Suervision. 2015. 1 December 2015 <https://www.federalreserveeducation.org/about-the-fed/structure-and-functions/banking-supervision>.
Mankiw, Gregory N. Principles of Economics. New York: Cengage Learning, 2008.
O’Connor, David Edward and Christopher C. Faille. Basic Economic Principles: A Guide for Students. New York: Greenwood Publishing Group, 2000.