Every country in the world has a central bank system that plays major roles in coming up with monetary theories. The USA is not left behind as it has had, over the years, a central bank, the Federal Reserve Bank (Fed). In 1913, the USA federal government saw the need to come up with the Federal Reserve Bank under the Federal Reserve Act. It is not fully public as it comprises of some private entities which are mostly banks. It has an outstanding structure which is comprised of: twelve regional reserve banks, Washington D. C.
’s board of governors and the federal government agency To understand the importance of the Federal Reserve Bank, it is good to know its history, how it started, its role in the economy, its past policies and current policies. More so, it will help in comparing the European banking system and the USA banking system and how they are both currently trying to solve the credit crisis (Allan, 2004). Role of the Federal Reserve System There are reasons for creating the Fed which is mostly to control banks from unnecessary panics. It does this by controlling the monetary policies.
The Federal Reserve system expects all banks to pay a ratio of the money they hold in their reserves; fractional reserve banking. For this purpose the banks do not have excess money to give to the people thus circulation of money in the economy is regulated by the Fed. The banks can not gibe a lot of money to its depositors, there has to be a limit of the amount of money a depositor can withdraw from an account daily. If banks are given the freedom to offer money the way they want, then it could result to high supply of money and later high and uncontrollable inflation rates.
The Fed has the mandate to respond to the way banks run their services. It controls this by either increasing or decreasing interest rates. When it increases deposit reserve interest rates, then private banks also increase deposit interest rates making customers to deposit money in banks leading to reduction of money circulating in the economy. This reduces the inflation rates as money is made scarce within the economy (Hafer, 2005). When money is scarce, then the Fed can reduce the loanable interest rates making banks to lend more thus individuals are able to invest raising the employment rates.
The Fed has the responsibility of setting the best monetary policies to avoid inflation or deflation caused via the banking sector. It is also responsible in increasing the faith and trust individuals are expected to have in the banking sector. For this purpose, it protects the banks by keeping some of its money in the reserve in case of bankruptcy; it can return a percentage of the money to the customers. It also sees that the people are not exploited by the banks when it comes to raising and lowering of the interest rate. It ensures that banks set the reliable deposit and loanable interest rates (Hafer, 2005).
The Fed controls money supplies within the economy under an Act known as elastic currency. It ensures that it can contract or expand the monetary supply depending on the economic situation at the time. The control of money supply is guided by the necessary theories within the expansion and contraction of money supply in the economy. The elastic currency has been the Fed’s role for a very long time. Since the great depression, the Fed has not used the contraction of money supply in the economy. This is because it is highly avoiding deflation which will lead to recession under the contraction of money supply.
What has been guiding the Fed in setting monetary policies is the fact that as the economy expands the money supplied is expected to expand too. This aims at meeting the large transaction rates in the economy. In 1907, the financial crisis that hit America led to some banks refusing to clear checks from other banks. There was great insecurity and faith in the banking system and this saw the need of the Fed to come up with a check clearing system. This is because payments in banks were delayed or not done at all. This was occurring all over the country and it led to some solvent banks closing down.
This made the Fed to come up with a check clearing system to ensure that the payments were done and to protect the solvent banks from falling (Hafer, 2005). For years, the Fed has played the role of the lender of the last resort. It gives specific entities credit when they are about to face economic failure that can lead to the whole economy suffering. It mostly lends money to the government when it has a deficit in its budget. It only gives a certain amount of money to ensure that the government does not exceed its debt rate. More so, sometimes there are seasonal fluctuations in the money market that can distort the nature of how banks work.
In such circumstances, the Fed lends money to the banks to help them perform its normal duties. The Fed charges a discount rate to the banks as it loans them the money. The discount rate determines how banks will set the loan and the deposit interest rates. If it is high then, the loan interest rates will be low while the deposit interest rates will be high. If they are low, then the loan interest rates will be high and the deposit interest rates will be very low. The Fed therefore acts as a booster in controlling the demand and supply of money in the country.
It makes the banking system to function effectively making people to gain faith in it thus saving more money thus investments increasing (Hafer, 2005). It also reduces the pressure in the reserve sector and controls the movements of the interest rates within the economy. A good example is the 85 billion dollars given to the American International Group (AIG) as it was facing bankruptcy in 2008. The Fed has been the government’s bank for many years. It is considered as the banker’s bank as it carries out some financial transactions for the government. It handles the government’s money which is always in trillions of dollars.
It is considered as the fiscal agent of the government. The treasury, of the government is responsible in checking the accounts kept in the Fed reserves. It is responsible in looking at the tax revenue that are incoming and the tax expenditure money the government is using. The Fed is also responsible in informing the government on the amount of money to deposit for its projects to avoid the account being negative. It is also responsible in the purchase and selling of government’s securities especially: notes, treasury bills, savings bonds and bonds.
In such transactions, the Fed ensures that monetary supply in the economy is also controlled. When it sells bonds to the general public, it receives money thus reduces the circulation of money in the economy. This gives the government money to finance its projects. On the contrary, it will buy bonds from the general public when it wants to reduce the supply of money in the economy. The Fed is receives notes and coins from the Bureau of Engraving and printing and the Bureau of the Mint so that it can issue them to the general public via the banking system.
When the government wants to do away with a specific printed note, the Fed via the banking system ensures that the specific notes stop circulating within the economy by applying the sale and purchase of bonds within the economy. It also plays a big role in the issuance of new coins and notes as printed by the two bureaus. This process uses the elastic currency policy that has been discussed in the previous pages (Hafer, 2005). The Fed is responsible in keeping the federal funds for private banks. Private Banks keep their money in the Federal Reserve to enable them to loan money to other banks.
Sometimes banks can loan money to other banks. Fed controls such transactions by keeping money for the banks. The Federal Reserve section is what brought about the name of the system and it also plays an important role in ensuring that the right monetary policies are made (Hafer, 2005). The Federal Reserve System is not allowed to give too many loans especially to entities that can not repay them. It has numerous responsibilities and this is one of them. It is expected to deal with the asset bubble effects that come about due to setting low interest rates for so long.
At the moment, the USA is facing a financial crisis due such mistakes made previously by the Fed chairman. Fed controls the amount of loan it gives to an entity to prevent bank run. It is responsible in carrying out research on how financial entities in the economy are fairing on. It immediately reports to the board of governors if a certain bank or financial entity is considered to be underperforming. When it has such information, it has the responsibility of finding out the reasons for underperformance. It takes look at all financial accounts of the entity and if the entity had given out false information, it is bound to be fined.
In the Act, anyone who over values property or gives out false financial statements is either imprisoned almost 30 years or fined one million USA dollars. Such laws help in the prevention of the asset bubble problem. All financial institutions are expected to give out the real value of its property not only to the Fed but also to its customers. This will prevent people from being lied to pay higher rates of mortgages. Fed is very much aware that the banks and all other financial institutions have become profit oriented and are ready to do anything to make a lot of profit.
If they are given such freedom, then it means that there will be no control of the supply of money leading to high inflation rates and unemployment rates. Fed, through its monetary policies reduces the unemployment rates which can be detrimental to the economy if left to increase (Hafer, 2005). The Federal Reserve System is independent of any government control. The president or any other person in the government has no right to influence its policies. Though it is independent, the USA congress is allowed to criticize its works and decisions.
It is expected to work within set financial and economic policies to ensure that the economy is quite stable. It is independent to prevent any government interventions that can lead to the misuse of money thus making inflation and unemployment rates to rise. Many governments who have not separated their central banks from the government have suffered the problem of misappropriation of funds thus have seen such countries being economically disabled. The Fed has the right to refuse to lend money to the government if a project is not valid. For this purpose, the USA government can not in any way misappropriate funds (Hafer, 2005).