How the Federal Reserve System Serves the Government

Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll explore the functions of the Federal Reserve System. You'll learn the services they provide for the government and banks, and we'll also discuss how the Federal Reserve affects the economy.

What is the Federal Reserve?

Tanya is a finance major at an Ivy League college. During the first week of school, the finance club is touring a local Federal Reserve Bank. As they're traveling to the bank, Tanya tells her finance professor she's excited to see how money is printed at the Federal Reserve Bank. The finance professor tells Tanya, ''Many think Federal Reserve Banks print money; however, that's one of the biggest misconceptions.''

For the rest of this lesson, we'll explore the purpose of the Federal Reserve Banks and how they serve the government and banks and maintain the economy.

Federal Reserve Banks

After the finance club arrives at the Federal Reserve Bank, they're greeted by Lynn, their tour guide and speaker. Lynn starts the tour by showing the group a 30-foot map of the 12 Federal Reserve Banks. The Federal Reserve Banks are strategically located throughout the United States to serve banks and the government.

Federal Reserve Bank

The Federal Reserve is managed by a Board of Governors in Washington, D.C. and each Federal Reserve Bank has a 9-member Board of Directors who oversee the daily operations.

The Federal Reserve, also called the Fed, handles financial transactions for the government. The Fed receives deposits from taxes, makes payments for government debt, completes wire transfers, and much more. Essentially, the Federal Reserve is the bank for the government.

The Federal Reserve also supervises and regulates banks, loans banks money, and sets reserve requirements. For example, you probably can't imagine trying to withdraw money from a bank and hearing the teller say, ''Sorry, we don't have the money at this time.'' This is because banks are required to maintain a certain amount of cash on hand called reserves. The Federal Reserve Board of Directors determines the reserve percentages, which range from 3% - 10%, depending on certain factors.

''For example, during Christmastime, do you believe the reserve requirements increase or decrease?,'' asks Lynn. The members of the finance club all say ''increases.'' Lynn asked, ''Why?'' Tanya raises her hand and explains that bank customers need more money during this time for gifts and travel. Lynn says, ''Exactly!''

During periods of heavy withdrawals, such as Christmastime, banks may need to borrow money to meet demand. If other financial institutions cannot meet the bank's loan request, they borrow money from the Fed. The Fed does not loan the banks money for free; they charge banks a discount rate, a percentage to borrow money, which can affect the consumer's cost for a loan.

The Cost of Borrowing

Lynn explains if banks can't borrow money for free, neither can consumers. Banks charge consumers interest. Interest is the consumer's cost to borrow money. Lynn tells the finance club to put on their thinking caps for the next question.

Lynn asks, ''If the Feds increase the reserve requirements, do banks have more or less money to loan?'' The finance club members think for a moment and say ''less.'' If the banks have less money, the interest rates they charge to consumers will increase since money is not readily available.

Oppositely, if the Feds decrease the reserve requirements, banks have more money to loan consumers and can reduce the interest rates they charge. The Feds can also affect the money supply by a committee within the organization called the Federal Open Market Committee (FOMC).

Federal Open Market Committee

The Federal Open Market Committee is within the Federal Reserve. The FOMC manages the country's money supply. Controlling the supply of money is important because too much or too little money can hurt the economy.

To stabilize the economy, the FOMC buys and sells government stocks and bonds. The government, like individuals and companies, invests money in the stock and bond markets. Investing in stock means purchasing a percentage of a company in exchange for voting on the company's major decisions and for a possible return on your investment in the future.

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