by Jorge Santiago
To increase the ease with which commerce is conducted and to control inflation, countries need a strong banking system. After all, there has to be some force working to ensure a country remains fiscally sound. America’s finances are governed by the Federal Reserve, the country’s central banking system. The Federal Reserve Act was signed into law in 1913 by President Woodrow Wilson, largely in response to the stock market panic of 1907, in which the New York Stock Exchange lost nearly half of its value within a year.
The central bank was initially charged with ensuring maximum employment and keeping inflation and interest rates in check, but its role has expanded over the ensuing century. Charged with managing the stability in the American economy, the Fed manages the country’s monetary policy and regulates other banking institutions as well.
Just as we deposit our paychecks at our banks, so too do our banks deposit their money with the Fed. But the central banking institution also requires that banks have a certain percentage of their deposits on hand at all times.
Generally speaking, to increase the flow of money and credit, the Fed buys assets with America’s fiat currency: the dollar. These assets are usually treasury securities purchased from banks. To pay for those securities, the Fed will credit the bank’s reserve the cost of those securities. Banks then have to keep a percentage of those deposits while lending the excess amounts to stimulate the economy. In theory, the Fed could purchase any amount of securities because it creates money.
When the Fed wants to decrease the flow of money and credit, it sells these securities. In such a scenario, the Fed reduces the banks’ accounts. Banks then have less money to lend, which likely increases interest rates and thwarts spending.
The establishment of the Fed wasn’t America’s first attempt at forming a central bank. At the behest of Alexander Hamilton, then secretary of the treasury, Congress established the First Bank of the United States in 1791. Then a country made up of farmers and merchants, most Americans were against the idea of a central bank. After its charter ran out 20 years later, Congress didn’t renew it.
Five years later, public sentiment shifted toward support of the bank. In 1816, the Second Bank of the United States was established. Populist Andrew Jackson was elected president in 1828 and vowed to defeat the bank. He was successful, as it wasn’t renewed following its 20-year charter either.
But it would still take another 77 years for today’s central bank to be established.
Today, the Federal Reserve is chaired by Janet Yellen, who is head of the Board of Governors, the banking system’s seven-member governing body. Each member of the board is appointed by the president and confirmed by the Senate to serve 14-year terms.
Headquartered in Washington, D.C., the central bank also consists of 12 regional reserve banks that are positioned in major cities around the country, the Federal Open Market Committee and other private banks and advisory councils. The federal government is the beneficiary of the Fed’s profit, less dividends paid to stakeholders. In 2012, $88.9 billion was deposited by the Fed in the Treasury.