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Economics U$A: 21st Century Edition

The Federal Reserve (Macroeconomics)

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The Federal Reserve was originally created in 1913 as an emergency lender to banks–a sort of bank of last resort. The Banking Act of 1935 and the Fed Accord of 1951 broadened the powers of the Fed, widening the range of options and tools it could use to manage the economy. Up to about 2010, the Fed did fairly well. But the housing bubble and Great Recession provided it with new and substantial challenges. These stories showcase the Fed’s capabilities while exploring how responsibilities and challenges have expanded over the years.

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Unit Overview

Purpose:

To show how the responsibilities and powers of the Federal Reserve have been broadened over the years, and indicate how the Fed can control the money supply and influence the level of interest rates and inflation.

Objectives:

  1. One of the most important functions of the Federal Reserve System is to ensure that the amount of money in the U.S. economy is consistent with noninflationary growth.
  2. The Fed controls the amount of money in the economy by controlling the reserves in the banking system. This is done in three ways:
    • Most often, the Fed injects or removes bank reserves by buying or selling government bonds in open market operations.
    • The Fed can also encourage or discourage bankers in their attempts to borrow reserves by lowering or raising the discount rate, which is the interest rate the Fed charges for its loans to banks.
    • The Fed can change the required reserve ratio or the percentage of deposits that a bank must keep in its vaults as reserves.
  3. If the rate of growth of the money supply is slowed, interest rates will initially rise and both economic activity and inflation will tend to slow down. The Fed cannot control how much the reduction in the growth of the money supply will affect economic activity and how much it will affect inflation.

Meet the Series Experts

Andrew Brimmer

Economist and expert on the world banking system, specializing in foreign debt obligations of Third World countries. He served as Assistant Secretary of Economic Affairs in the U.S. Department of Commerce, under President John F. Kennedy, and in 1966 President Lyndon B. Johnson appointed him to an eight-year year term on the Board of Governors of the Federal Reserve System, the first African American to serve. Later, he taught at Harvard University, formed his own consulting company, Brimmer & Co., and in 1997 returned to the Federal Reserve as Vice Chairman. He was elected to the Washington Academy of Sciences and has served as Vice President of the American Economic Association, President of the Eastern Economics Association, and President of the North American Economics and Finance Association. Dr. Brimmer received his B.A. and M.A. from the University of Washington and a Ph.D. in Economics from Harvard University. He was a Fulbright Scholar at the Delhi School of Economics.

Benjamin Bernanke

Chairman of the Board of Governors of the Federal Reserve System, since 2006, and Chairman of the Federal Open Market Committee, the System’s principal monetary policy-making body. In 2001, he became Editor of the American Economic Review. In 2002, he was appointed as a member of the Federal Reserve Board, where he served until becoming Chairman of the President’s Council of Economic Advisers, 2005–2006. Before these appointments, he was a Professor of Economics at Princeton University. Presiding during a period of economic turmoil, his Federal Reserve chairmanship has been contentious. While many of his efforts have been extolled, he has also shouldered criticism for the economy’s slow recovery from the Great Recession of 2008. Dr. Bernanke received his B.A. from Harvard University and Ph.D. from the Massachusetts Institute of Technology.

Lester Chandler

Adviser to the federal government during World War II, valued for his expertise in monetary policy. During the war, he was associated with the rubber and chemical branches of the Office of Price Administration. After the war he conducted research for the Congressional Subcommittee on Monetary and Fiscal Policy of the Joint Economic Committee and became Public Director and Deputy Chairman of the Board of Directors of the Federal Reserve Bank of Philadelphia. He also had a distinguished academic career, beginning at Dartmouth and Amherst Colleges, then at Princeton University where he was twice Chairman of the Department of Economics and served as Acting Director of Princeton’s Woodrow Wilson School of Public and International Affairs. Dr. Chandler received his B.A. from the University of Missouri and Ph.D. in Economics from Yale University.

Donald Kohn

Vice Chairman of the Board of Governors of the Federal Reserve System, 2006–2010, and Member of the Board of Governors, 2002–2008. Earlier, he served on the Board staff as Adviser to the Board for Monetary Policy, Secretary of the Federal Open Market Committee, Director of the Division of Monetary Affairs, and Deputy Staff Director for Monetary and Financial Policy. He also held several positions in the Board’s Division of Research and Statistics, including Associate Director and Chief of Capital Markets. He has written extensively on issues related to monetary policy and its implementation by the Federal Reserve, and his work has been published in volumes issued by the Federal Reserve System, the Bank of England, the Reserve Bank of Australia, the Bank of Japan, the Bank of Korea, the National Bureau of Economic Research, and the Brookings Institution. Dr. Kohn received his B.A. from The College of Wooster and Ph.D. in Economics from the University of Michigan.

What's your Economics IQ?

Take the Economics USA: The Federal Reserve Quiz.

Quiz Addendum

3. Answer explanation:
The Fed issues loans to help banks through hard times, not to encourage profits. The third response is partially correct, since the Fed will obviously favor low-risk investments over high-risk ones. But the more important point by far is that the Fed does not provide assistance to banks so that they can turn around and use the money to make a profit; the purpose of the loans is to keep banks solvent when they run into difficulty.

5. According to the balance sheet below for the Fed and the member banks, we can infer that the Fed has:

Effect on Fed’s Balance Sheet
Assets Liabilities and Net Worth
Government securities (+ $1 million) Government bank reserves (+ $1 million)
Effect on Banks’ Balance Sheet
Assets Liabilities and Net Worth
Reserves (+ $1 million) Demand deposits (+ $1 million)

 


Answer:
purchased government securities, thereby increasing the money supply.

Glossary

  • discount rate
    The interest rate the Federal Reserve charges for loans to commercial banks.
  • Federal Reserve System
    A system established by Congress in 1913 that includes commercial banks, the twelve Federal Reserve Banks, and the Board of Governors of the Federal Reserve System.
  • money supply
    The total amount of money that is available to be spent in an economy at a given time. Currency is only one component of the money supply.
  • open market operations
    The purchase and sale of U.S. government securities on the open market by the Federal Reserve in order to control the quantity of bank reserves.
  • required reserve ratio
    Amount of money and liquid assets that Federal Reserve System member banks must hold in cash or on deposit with the Federal Reserve System, usually a specified percentage of their demand deposits and time deposits.

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Economics U$A: 21st Century Edition

Credits

Produced by the Educational Film Center. 2012.
  • Closed Captioning
  • ISBN: 1-57680-895-5