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Overview of the Federal Reserve System & its Processes

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  • 0:01 What Is the Federal Reserve?
  • 1:29 Reserve Ratios
  • 2:30 Discount Rates
  • 3:56 Open Market Operations
  • 4:55 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught middle and high school history, and has a master's degree in Islamic law.

Just about every week, you hear something in the news about the Federal Reserve, but what is it? What do they do that makes them so important? In short, as this lesson explains, they determine how much money is in the economy.

What is the Federal Reserve?

We all know how useful banks are to a community. They hold money for safekeeping, offer loans and provide checking services so you don't have to carry all your money with you everywhere. But who serves as a bank for the banks? Don't the banks have a need for occasionally borrowing money? And who tells the banks how much money they can loan? In short, that's what a central bank does. Just about every country has a central bank - a bank that acts as a bank for the other banks. In the United States, the central bank is called the Federal Reserve and it's far from being just a typical bank.

In short, the Federal Reserve is the only entity that is allowed to create money. Let a minute pass so you understand how much power that involves - with a phone call, they can tell the Bureau of Engraving and Printing to literally copy millions of dollars! In reality, though, the Fed (as it is often called) very rarely works like that. However, due to its ability to control interest rates, determine reserve ratios and sell Treasury bonds, the Fed controls the money supply. These efforts by the Federal Reserve to manage the money supply are referred to as monetary policy.

Reserve Ratios

As an owner of a bank, keeping good terms with the Fed is simply good business sense. In fact, you are their primary customer! Let's say that you own a bank that specialized in offering student loans. Needless to say, around September, you are probably running low on cash reserves. Remember, banks also have people who deposit money who expect to be able to access it whenever they want, so you have to make sure that you keep a certain percentage of your holdings as cash in the vaults. This is called the reserve ratio, and it is one of the principle ways that the Fed controls the money supply through banks. It is also sometimes called the reserve requirement. If the Federal Reserve sets a low reserve ratio, that means banks can lend out a higher percentage of their deposits. In the United States, the reserve ratio for larger banks tends to hover around ten percent.

Discount Rates

Among the jobs of the Fed is to be a lender of last resort for banks. If a bank is running low on cash, it is supposed to call its neighbor banks first and have them loan the money. The idea is that if a single large customer suddenly withdraws all her money, the bank may drop below its reserve ratio. In this case, banks are able to typically make up the difference by borrowing from other banks.

However, what happens if all the banks in an area suddenly see people withdrawing all their money? This would mean that banks were unable to meet all their withdrawal requests, and some could go out of business. To prevent this from happening, the government allows banks to borrow money from the Fed.

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