Development of Modern Banking in the United States

By the turn of the century, the National Banking System (NBS) was becoming less effective due to several reasons:

It could not provide enough currency for the growing nation.
Checking accounts were becoming more popular, and the NBS was not designed to handle them.
It was not equipped to ensure the stability of the currency or the money supply.

The Need for a Central Bank

Congress recognized the necessity for a new central bank.

A central bank is defined as a public institution that manages a state's currency, money supply, and interest rates.
Central banks also typically oversee the commercial banking systems of their respective countries.
A central bank has the ability to lend money to other banks.

The Federal Reserve System

In 1913, Congress established the Federal Reserve System as the nation's central bank.

Goals of the Federal Reserve System

The Federal Reserve System has four main goals:

Sustainable growth
Maximum employment
Stable prices
Moderate long-term interest rates

Key Aspects of the Federal Reserve System

Money (dollars) used in the United States is issued by the Federal Reserve System and are referred to as Federal Reserve notes.
Based in Washington, D.C., the Fed serves as the bank of the U.S. government and regulates the nation's financial institutions.
It comprises a network of 12 Federal Reserve Banks and a number of branches.
Besides being the nation's central bank, the Fed studies economic trends and formulates policy decisions on how to improve the economy.
The Fed operates as an independent agency, allowing it to make decisions without requiring approval from any other branch of government.
It is overseen by the Fed's Board of Governors.
Fed board members are nominated by the President and must be approved by the Senate.
The Board of Governors consists of seven members, each serving a full term of 14 years.
Jerome H. Powell is the current chair of the Board of Governors of the Federal Reserve System.

Fractional Reserve Banking

Fractional reserve banking is a system where banks hold only a fraction of their customers' deposits as reserves to meet potential withdrawal requests. These reserves are held as physical currency within the bank or as balances in the bank’s account at the central bank.
Bank deposits are generally considered a form of money allowing the money supply to expand to a multiple of the initial base money created by the central bank. This multiple is known as the money multiplier.
Fractional reserve banking is the current form of banking practiced in all countries worldwide.

How the Fed Accomplishes Its Goals

The Fed achieves its goals through monetary policy, which is a set of tools a nation's central bank uses to promote sustainable economic growth by managing the nation's overall supply of money available to banks, consumers, and businesses.

Monetary policy focuses on controlling the money supply.
Fiscal policy relates to government income and expenses.

Monetary Policy Tools

The Fed uses three primary tools for monetary policy:

Setting the discount rate and federal funds rate
Setting reserve requirements
Open market operations

1. Setting the Discount Rate and Federal Funds Rate

The Fed can raise or lower interest rates that banks pay to borrow money, influencing how expensive or cheap it is for banks to lend money to people and businesses.
Banks borrow money in two main ways:
- From each other, using their reserves at the Fed, which incurs the Federal Funds Rate.
- Directly from the Fed, which incurs the discount rate.
The Fed controls both the Federal Funds Rate and the Discount Rate.
Banks need to borrow to maintain reserve requirements, which the Fed also sets.
These rates influence the prime rate, which is the rate banks charge their best customers. This directly affects rates for mortgages, car loans, and other types of credit.

Influencing Interest Rates

The Fed changes its stance on monetary policy primarily by adjusting its target range for the federal funds rate.
Lowering rates is an easing of monetary policy, which may be necessary if the economy is sluggish or inflation is too low.
Raising interest rates is a tightening of monetary policy, which may be necessary if the economy is overheating or inflation is too high.
Changes in the federal funds rate typically affect and are accompanied by changes in other interest rates and financial conditions, which in turn influence the spending decisions of households and businesses, and subsequently economic activity, employment, and inflation.

2. Changing the Reserve Requirement

The reserve requirement is the proportion of customers’ deposits that a bank is required by the Fed to hold in reserve, without lending it out.
Lowering the reserve ratio expands the money supply, while raising the reserve ratio contracts the money supply.

3. Open Market Operations

Open market operations involve buying and selling government securities.
Buying government securities expands the money supply, while selling them contracts the money supply. These securities are also known as Treasury bonds.

How Monetary Policy Affects the Economy

Interest rates affect people and firms’ demand for goods and services.
Buying and selling government securities either injects more money into the economy or withdraws money.
The reserve requirement also influences the amount of money in the economy.

All of these factors influence inflation and people’s and firms’ expectations about the future.

Effects of Monetary Policy on Economic Decisions

Do firms want to expand their businesses?
How much expansion is prudent?
How much money can firms afford to borrow, and thus expand?
Can banks loan money to businesses, and at what interest rate?
Can individuals buy a new house or a new car, and what can they afford?
Can banks loan individuals money, and at what rate?
Should individuals refinance their mortgages?

Key Questions and Answers

What are the four goals of the Federal Reserve, and how does the Fed accomplish those goals?
- Sustainable growth
- Maximum employment
- Stable prices
- Moderate long-term interest rates
The Fed accomplishes these goals through monetary policy, which involves using tools to control the nation’s money supply and promote sustainable economic growth.
What is fractional reserve banking, and how can it be used to affect the money supply?
- Fractional reserve banking is a system in which banks hold only a fraction of their customers’ deposits as reserves.
- Since bank deposits are considered a form of money, they can expand to a multiple of the initial base money created by the central bank, known as the money multiplier.
- Fractional reserve banking allows for the expansion of the money supply based on the reserve requirements set by the central bank.