Smale noted that by 1913, America’s economic growth both at home and abroad required a more flexible, yet better controlled and safer banking system. This, according to her, led to enactment of The Federal Reserve Act in 1913 which established the Federal Reserve System as a central banking authority of the US.
The Federal Reserve System is basically a decentralized central bank headed by a seven member Board of Governors of Federal Reserve System “who control operations of twelve Federal Reserve banks, several monetary and consumer advisory committees and thousands of member banks” (Smale). It is important to note that the Federal Reserve System is an independent entity that was created to enable the central bank to discharge its responsibilities in an atmosphere that is protected from excessive political and private pressures. That is why it is by law accountable to congress. The seven members of the Board of Governors are appointed by the president and confirmed by the senate (Smale).
According to Jones (2006) the system includes twelve reserve banks, each with a board of directors. He noted that the decentralized structure provides accountability and at the same time avoids centralized government control
The Federal Reserve System uses several means to guide American economy. First, the federal reserve system sets the nations monetary policy to promote the objectives of maximum employment, stable prices and long term interest rates, in their publication, the Board of Governors of the Federal Reserve System, noted that when prices are stable, prices of goods and services, materials and labor are undistorted by inflation and serve as guides to efficient allocation of resources thereby contributing to higher standards of living (p15). As an independent entity that attends to the nation’s credit and monetary policy needs, the Federal Reserve System’s monetary policy operations are intended to promote stability in the nation’s economy.
Formulation of monetary policy as mentioned above is done by the Board of Governors. Smale advised that monetary policy entails increasing and decreasing money supply in the economy which in turn stabilizes interest rates in order to achieve macroeconomic objectives. This is done, according to her, by use of economic instruments at the board’s disposal, which alters availability and cost of money in the economy. One of the instruments is for instance, legal reserve requirement which requires depository financial institutions to “set aside reserves in certain proportions against demand deposits” (Smale, p.4)
Concerning Federal Reserve System’s supervisory and regulatory responsibility, Smale noted that the board “seeks to promote, safety and soundness, ensure compliance with laws and regulations, and foster the fair and efficient delivery of services to customers of financial institutions” (p.5). She added that, guided by regulations defined by congressional legislation, the board exercises power to “examine all member banks and their affiliates and to require periodic reports from them” Smale, p.5).
According to Federal Reserve Board, supervision entails monitoring, inspecting and examining banking organizations with a view to assessing their condition and how they comply with various laws and regulations, since banks operate within specific regulatory frameworks. On the other hand, regulation is the act of issuing actual guidelines that govern the operations and activities of banking organizations (Federal Reserve Board.)
What happens when a bank fails to comply with laid down procedures?
When a banking organization within the Federal Reserve’s supervisory authority is found to be non compliant or to have other troubles, the Federal Reserve may use its supervisory authority to take formal or informal action to have the organization correct the problem.
(Federal Reserve Board, 2005, p 59)
Further guide to the economy is accomplished by Federal Reserve System’s attempts to maintain financial stability. In his book about central banks, Jones, (2006) reported that the Federal Reserve System maintains both financial and ultimately political stability in the nation. He noted that the most visible means by which this is done is through discount rates: “when rates are low economic activity increases and economy grows, if economy grows too fast, the federal reserve system raises interest rates as a means of ensuring price stability and protecting against inflationary pressures” (p. 412). He added that, during crises (like the stock market crash of 1987) the federal reserve springs in to action ensuring monetary liquidity by availing cash or extending discount loans to depository institutions in order to keep interest rates at a manageable level.
The Federal Reserve System’s main tool for fighting inflation and recession is what Jones (2006) called ‘open market operations’ (p. 418). He explained that acting through banks and government securities dealers, the federal reserve “buys and sells government securities on the open market to influence short term interest rates and the growth of money and credit” (p. 419). It can be seen here that when the Federal Reserve determines that too much money and credit are available in the market and inflationary pressures are rising, they sell securities to banks and other dealers. This leads to a situation where banks are starved of money-which they lend to the public-thereby reducing inflation and stabilizing the economy. As far as the opposite is concerned, if too little money is available in the economy, the Federal Reserve buys securities. The funds used to buy securities eventually find their way to banks, which readily lends the money to the public. This moves money to the financial system and equally stabilizes the economy
It can be argued that the Federal Reserve System is a unique American central bank which fulfills important responsibilities-fighting inflation, setting monetary policy, supervising financial institutions and providing financial services to banks. The system has been a success I instilling confidence in the US economy. Since it has been the foundation for a stable US economy, it will undoubtedly play a significant role in steering America out of the current economic quagmire.