Mac Econ Chap 11 – The Federal Reserve System

Chapter 11:



The purpose of monetary policy is to control money supply in order to make sure that sufficient amount of money is available for economic growth, but, more importantly, to prevent the money supply to be excessive which would cause the value of money to decrease. The responsibility of monetary policy is in the hands of the Federal Reserve System.

Preserving the value or price of money could in principle be accomplished by affecting the demand or supply of money. Control over supply is the only one really possible. An example of such control would be the printing of bank notes being the responsibility of the Federal Reserve. Except that bank notes represent a very small part of money. Thus, control over other forms of money, such as checking accounts, is more important.


The major purpose and function of the Federal Reserve System is monetary policy through control of money supply. The Board of Governors has the responsibility for setting the policy. It is helped by the Open Market Committee and the Federal Advisory Council. Other functions include clearing checks, printing new currency, control of foreign exchange markets, supervision of banks and acting as fiscal agent for the government.

Each State of the United States has its own laws and authorities to supervise banks. The Federal Reserve role is at the national level: how banking activities affect the entire country. An example of such national role is the intervention whenever necessary to maintain the price of our currency in term of foreign currencies, i.e. foreign exchange rates.


The Federal Reserve System was created by the Federal Reserve Act of 1913 when an excessive decentralization of the banking industry started to impede economic development. The FRS is made of twelve regions each with a Federal Reserve Bank, which directly supervises commercial banks, and indirectly oversees the reserves of savings banks and other financial intermediaries. The Federal Reserve System is known as the Fed.

As the name indicates, the Federal Reserve is supposed to provide reserves. Prior to the Federal Reserve Act of 1913, periodic bank failures were caused by insufficient reserves of given banks. These bank panics and “runs on the banks” undermined public’s confidence in banks and money in general.


Federal Reserve Banks are quasi public institutions in that they are owned by the commercial member banks but are operated as not for profit institutions. They hold the reserves of member banks and act as lenders of last resort. They also carry out the various functions of the Federal Reserve System.

The subdivision of the Federal Reserve in 12 regions is necessary to reflect the different economic needs the banking community is serving. In 1989 for instance, the needs of businesses in the relatively prosperous New England region were quite different from those of agricultural firms in the Midwest.


The banking industry in the United States is supervised by the Fed. Its structure is essentially the result of the Federal Reserve Act of 1913. There are 15,000 commercial banks, a third of which are national banks and full members of the FRS. State commercial banks, as well as over 30,000 savings and loan associations and credit unions, must also comply with reserve rules since the Depository Institutions Deregulation and Monetary Control Act of 1980.

Today’s banking is changing: securities firms and insurance companies seek to offer services similar to those of commercial banks. Commercial banks want to enter the securities and insurance fields. Still, banking essentially consists in receiving small deposits which can be combined to make loans to businesses and individuals that need them.

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