Numerous countries have central banks that play a crucial role in maintaining a proper monetary framework for their economies and perform a few other vital tasks. The US is one of them as it boasts a highly effective complex system of banks that perform central bank’s duties jointly. The Riksbank, Sweden’s central bank, was established in 1668 and proved to be extremely beneficial for the economy in general. Most European countries followed the example since having a central bank provided numerous advantages. Nevertheless, the US, which has always had a different market freedom approach, did not consider creating such an institution at the federal level until the 20th century. By that time, it became vivid that the economy needed a dedicated system of banks capable of providing the proper amount of cash and volume of credit to individuals and businesses.
The Structure and Functions of the Federal Reserve System
The Federal Reserve System (FRS) was established with the Federal Reserve Act of 1913 and began operations in 1914. The whole nation was divided into Federal Reserve Districts, with a major bank in each of them. These banks are authorized to issue paper money to commercial banks. Moreover, the Fed has plenty of other duties alongside this activity. According to Arnold (2019), there are many functions of the Fed: supplying the economy with paper money, controlling the money supply, holding depository institutions’ reserves, providing check-clearing services. Moreover, the Fed supervises member banks, serves as the government’s banker and handles the sale of U.S. Treasury securities. Therefore, the System not only serves as the major bank of the nation but also controls the performance of other banks and assists the government in terms of financial transactions. What is more, it initiates the money supply expansion and contraction processes.
The monetary tools the Fed uses have become especially important since the end of the 20st century, when monetarism became popular. Controlling inflation and ensuring a modest expansion of money supply, which correlates with economic growth, are now considered the most efficient and practical macroeconomic tools by many economists. The theory itself is based on the assumption that market forces can mitigate inflation, unemployment, and recession on their own if the money supply growth is reasonable.
Therefore, the Fed often needs to boost the money supply expansion process. Arnold (2019) states that the System conducts an open market purchase in order to do this. For instance, the Fed can purchase government securities from a commercial bank. The bank expects to be paid for turning over the government securities. The Fed can pay any amount of money needed for the transaction as it is authorized to produce money out of thin air. This money becomes a new deposit which can be created for a client. Thus, the money supply increased by that amount of money. Nevertheless, that is not always the main objective of the Fed. Sometimes, it needs to initiate the money supply contraction process. In this case, the Fed starts an open market sale, meaning that it sells government securities. The money that is transferred to the bank simply disappears in this case, as the Fed is authorized to perform such an undertaking.
Another tool that the Fed can use in order to regulate the money supply is the discount rate. It represents the interest rate that the Fed sets for the loans which commercial banks can receive from it. The Fed can increase the money supply by setting the discount rate lower than the federal funds rate. In order to contract the money supply, the Fed has to do the opposite. Moreover, the Fed is in charge of the federal funds rate target. The System is expected to undertake open market operations needed to reach it.
The Federal Reserve System’s activities are mainly controlled by the Board of Governors. The policy-making group is called the Federal Open Market Committee, which is made up of members of the Board of Governors and Federal Reserve District Bank presidents. Such a comprehensive structure ensures the entire institution’s proper functioning and allows for a coordinated monetary policy in such a large economy. It is of major importance to distinguish between the Federal Reserve System’s functions and those of the U.S. Treasury. Their activities jointly enhance the economy’s performance, but each of them has a unique set of tools. The major difference is that the U.S. Treasury is a budgetary agency, meaning that it is in charge of taxes and borrowings. It is directly obliged to manage the federal government’s financial affairs, while the Federal Reserve System has no similar duties. Moreover, the Fed has an exclusive right to create money, while the U.S Treasure is in charge of Treasury securities.
The Federal Reserve System’s Recent Actions
During the COVID-19 pandemic, the government and other institutions sought to implement various policies in order to mitigate the crisis. Monetary policies were used alongside fiscal stimulus, as the Federal Reserve funded large-scale corporate bond purchases. In mid-March, the Fed took multiple actions to improve the functioning of the market. Sharpe and Zhou (2020) state that the Fed created credit facilities and liquidity to enhance the supply of liquidity and to fuel the demand for debt securities. The Fed has undertaken a significant number of serious measures to boost the economy and stop the unemployment rate growth. Moreover, the Fed performs well when it comes to making forecasts during these turbulent months. Chang (2020) states that the Board of Governors has recently introduced a new dataset designed to provide approximate weekly forecasts that prove the accuracy of the large-scale GDP forecasts.
Nevertheless, some scholars argue that the quantity theory should still be concerned when implementing such measures. Robert L. Hetzel (2020) states that the current situation in the economy and the Fed’s actions resemble the Great Inflation that took place in the mid-1960s-1970s. Moreover, he claims that the Fed has decided to revert to its 1950s “cost and availability” view of monetary transmission. Ashraf (2020) claims that quantitative easing has become a ubiquitous term in the media and everyday discourse since the Great Recession. Such actions may lead to uncontrolled inflation in the near future. Nevertheless, inflation is increasingly seen as a nonmonetary phenomenon by some economists. Therefore, Americans are yet to witness the results of the Fed’s current active policy. Although the real repercussions of the economic crisis are not clear, numerous studies show that the financial markets are not driven by pure enthusiasm, as described in many journals. For instance, Chen et al. (2020) argue that the financial markets continued to correlate with near and medium-term economic conditions during the recent rally. Thus, the strategy behind the Fed’s current actions should not be undermined.
The Federal Reserve System has played a vital role in shaping the monetary framework, which allows for the economy’s proper performance in general. The fact that this institution enjoys a certain degree of autonomy and is not obliged to finance government spending ensures the sustainability of the entire financial system. The Fed enjoys a wide array of tools that can help the economy improve without undermining market forces even during the COVID-19 pandemic.
Arnold, R. A. (2019). Macroeconomics (13th ed.). Cengage.
Ashraf, M. (2020). Money. Palgrave Macmillan.
Chang, A. C., & Levinson, T. J. (2020). Raiders of the lost high-frequency forecasts: New data and evidence on the efficiency of the Fed’s forecasting [PDF document]. Web.
Chen, A., Ibert, M., & Vazquez-Grande, F. (2020). The stock market–real economy “disconnect”: A closer look. Federal Reserve System. Web.
Hetzel, R. L. (2020). COVID-19 and the Fed’s monetary policy. Web.
Sharpe, S., & Zhou. A. (2020). The corporate bond market crises and the government response. Federal Reserve System. Web.