Federal Reserve System & historical perspective

The Federal Reserve System is the Central Bank of the United States. Historically, people used to store their money in the form of gold, which would be deposited with a Goldsmith, who would give them a receipt in return to the gold, thus a Goldsmith performed some of the major functions that banks perform today. Because gold was inconvenient to carry around and susceptible to theft, people began to place their gold with the goldsmith for safe-keeping.

On receiving the gold, the goldsmith would issue a receipt to the depositor, charging him a small fee for looking after his gold. After a time, these receipt themselves rather than the gold rather than the good they represented began to be traded for goods. The receipt became a form of paper money, making it unnecessary to go to a goldsmith to withdraw gold for a transaction (Case and Fair 488). Hence, goldsmiths functioned as warehouses where people stored gold for safekeeping.

Goldsmiths on the other hand, instead of just keeping the gold idly in their vaults, earned interest on them by issuing them in the form of loans and earning interests on them, i. e. the goldsmiths changed from being mere depositories into bank-like institutions that had the power to create money (Case and Fair 488). But the problem here was that by making loans, goldsmiths increased the amount of money in circulation without adding more gold, just by adding additional claims to the gold. Thus there were more claims than there were ounces of gold.

Hence, if a run on goldsmith occurred during that point in time, i. e. people who had deposited their gold would all come together reclaiming their gold back, the goldsmith wouldn’t have had sufficient amount of gold available as he had loaned them out. FEDERAL RESERVE SYSTEM This is the case with today’s banking system, where private banks loan out money, which actually means they create money, and the Fed or the Federal Reserve System is available as a supervisory body, which ensures protection to banks incase a run on bank occurs.

However, the major function of the Fed is the controlling of the money supply, which affects the interest rates and thus controlling the entire economy, which will be discussed in some detail in the paper. The private banks are not free to create money by making loans at will. Their ability to create money is controlled by the volume of reserves in the system, which is controlled by the Fed. The Fed, therefore has the ultimate control over the money supply (Case and Fair 490). It was founded in 1913 by an act of Congress (to which major reforms were added in the 1930s), the Fed is therefore the Central Bank of United States.

The Fed is a complicated institution with many responsibilities, including the regulation and supervision of over 8000 commercial banks. The Board of Governors is the most important within the Federal Reserve System. The board consists of seven members, each appointed for 14 years by the President of the US. The chair of the Fed, who is appointed by the President and whose term runs for 4 years, usually dominates the entire Federal Reserve System and is sometimes considered to be the second most powerful person in the United States.

The Fed is an independent agency and it does not take orders from the Congress or the President. The United States is divided into 12 Federal Reserve districts, each with its own Federal Reserve Bank. The district banks are like branch offices of the Fed, where they carry out the implementation of the rules and regulations, and functions of the central system in their districts and report to the Board of Governors on local economic conditions.

The behavior of the Fed concerning the money supply is formally set by the Federal Open Market Committee (FOMC). The FOMC consists of the seven members of the Fed’s Board of Governors, the president of the New York Federal reserve bank, and, on a rotating basis, four of the presidents of the 11 other district banks. The FOMC sets goals concerning the money supply and interest rates, and it directs the Open Market Desk in the New York Federal Reserve Bank to buy and/or sell government securities (Mankiw 335).