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What is the Federal Reserve System?

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  • 0:05 What Is the Federal Reserve?
  • 2:03 Main Goals of the Fed
  • 3:01 How the Fed Achieves…
  • 6:53 The Money Supply and the Fed
  • 7:27 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

Have you ever wondered why interest rates go up and down, seemingly at random? Of course you have! Discover what the Federal Reserve is, what its goals are and how those goals are achieved in this introductory lesson explaining the central bank of the United States.

What Is the Federal Reserve?

What if you had the power to create money out of thin air? How would you view the world? What would you do with the money you create? Would you take it up in a helicopter and drop it off the tallest building in the world? Would you use it to buy gold bars and stack the gold in the shape of the pyramids of Giza? Perhaps you would use it to help as many people as possible afford a college education. The Federal Reserve is the only organization in our society that has the authority to legally create money out of nothing. What an awesome power!

The Federal Reserve's power comes from its ability to issue money, called Federal Reserve Notes. While many people confuse it with the Bureau of Engraving and Printing, which is part of the Treasury Department, the Federal Reserve is actually not a federal agency. However, its power was delegated to it by Congress in the early 20th century. It doesn't actually run the printing presses where the currency is produced (that's the Treasury Department), but it does create money by increasing bank account balances. This creative power comes from the fact that it's at the very top of a giant pyramid of banking.

The Federal Reserve is at the top of the banking pyramid
Federal Reserve Pyramid Illustration

The Federal Reserve (called the Fed for short) is the central bank of the United States. Founded in 1913 by an act of Congress called the Federal Reserve Act, it's considered the government's bank as well as the banker's bank. It's also referred to as 'the lender of last resort' because of its ability to step in and loan out money when banks get into trouble. In doing so, it creates stability in the financial system and helps to reduce the severity of economic downturns.

Main Goals of the Fed

Its main goals, at least since 1977, have been to promote maximum sustainable output and employment and to promote stable prices.

Here's what they say about themselves: 'The Federal Reserve sets the nation's monetary policy to promote the objectives of maximum employment, stable prices and moderate long-term interest rates.'

What does that mean? It means they want to see as many people as possible in the town of Ceelo working jobs. It means they don't want to see the prices in the grocery store rising too fast. When prices are somewhat stable, this helps a nation maximize its output while improving its standard of living. Finally, it means the Fed wants interest rates at the First National Bank of Ceelo to be low enough to encourage people to borrow and invest.

How the Fed Achieves Its Monetary Goals

How does the Fed achieve these goals? By controlling the money supply.

The money supply is a stock of safe assets that households and businesses can use to make payments or to hold as short-term investments. Common examples of the money supply include the currency and coins in circulation, but also checking and savings accounts, like the one Margie deposits her paycheck into when she goes to the First National Bank of Ceelo.

The actions taken by the Federal Reserve are often too complex and difficult for many people to figure out, although they have a track record of delivering positive results. Here's a more detailed list of the important functions that the Fed performs:

  • Acts as the lender of last resort to commercial banks
  • Regulates the money supply
  • Holds deposits of banks
  • Supervises the banking system
  • Provides check-clearing services

One thing the Federal Reserve does not do is bank with individuals, so it cannot extend any credit to individuals.

The Fed is able to exercise considerable control over the money supply and interest rates because commercial banks are required to maintain a reserve account of their own at one of the Federal Reserve Banks throughout the country. That's why it's referred to as 'the banker's bank.' Banks are required to keep some of their own money in an account at the Federal Reserve, and the Fed determines the interest rate these banks pay to borrow money. All of the other bank interest rates that affect everyday citizens, like you and me, are somehow tied, either directly or indirectly, to this main interest rate they call the Federal Funds Rate.

When the economy is doing really well, the Fed tends to keep interest rates on the higher side. When the economy is doing very poorly, on the other hand, they tend to keep interest rates on the low side in an effort to jump-start the economy's engine.

When the economy is doing poorly, the Fed tends to keep interest rates low
Federal Funds Rate

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