Functions of the Federal Reserve System

The Fed performs a number of important func­tions in the American economy, the most important of which is controlling the nation's money supply. Let us briefly examine some of the other functions of the Fed before we study in detail how it affects the amount of money in circulation.

One of the major functions of the Fed is clearing checks. Each year billions of checks are written by individuals, businesses, and the var­ious agencies of government. Each of these checks represents an order to transfer funds from the account of the check writer to the recipient of the check. Sometimes the check-clearance procedure can be very simple. For example, suppose you write a check for $20 to a local store in payment for merchandise. If the store owner banks at the same bank as you, when he or she deposits the check at the local bank, the bank can simply subtract $20 from your account and add $20 to the account of the store owner. However, the check clearance procedure for many checks is far more compli­cated, and the Federal Reserve Banks play an important role in the process. In order to better understand how the check clearance system works, let us look at a specific example.

Suppose Pamela Rissler of Albany, New York, mails an order for art supplies along with a check to an art supply store in Sacramento, Cal­ifornia. Figure 12—3 shows the various steps involved in clearing this particular check. As you can see from the chart, the art supply store will deposit Pamela's check in its account at a Sacramento bank. The Sacramento bank in turn will deposit the check in its account at the Fed­eral Reserve Bank of San Francisco. The Feder­al Reserve Bank of San Francisco will ,send the check to the Federal Reserve Bank of New York, which will deduct the amount of the check from the account of Pamela's bank in Albany and then forward the check to Pamela's bank. Finally, Pamela's bank will deduct [the amount of the check from her account and mail the canceled check to Pamela along with her other checks that have been processed that month.

The Fed also serves as a fiscal agent for the federal government. The U.S. Treasury collects

huge sums of money through taxation and then deposits much of this money in Federal Reserve
Banks. The Treasury then keeps checking accounts for such things as tax refunds and
Social Security payments. Moreover, the Fed helps the Treasury in its efforts to borrow money by selling government securities, such as U.S. Treasury bonds.

In addition, the Fed performs various supervisory functions intended to ensure that the member banks are in compliance with the banking laws and that they are engaging in sound banking practices. Among these func­tions are making sure that member banks have adequate funds, overseeing bank mergers, and setting limits for loans by member banks. Because national banks are supervised by the Comptroller of the Currency, a federal agency the Fed's primary supervisory responsibility is overseeing the operations of member state banks. The Fed also works closely with another federal agency, the Federal Deposit Insurance Corporation, in making sure that all bank deposits are insured.

Another responsibility of the Fed is to hold required reserves. Banks and other financial institutions are required by law to keep a cer­tain percentage of money that is deposited with them as required reserves to back up the depos­its. One of the important functions of each Federal Reserve Bank is to hold the required reserves of the depository institutions within its district. As you soon will learn, changing the percentage of deposits that must be kept as required reserves is one of the ways the Fed can increase or decrease the money supply of the nation.

The Fed also is responsible for supplying paper currency. As you learned in Chapter 11, paper currency in the United States consists almost exclusively of Federal Reserve notes issued by the Federal Reserve Banks. The actu­al printing of the notes is done by the Bureau of Engraving and Printing in Washington, D.C. However, each Federal Reserve note has a seat' on the left side of the front indicating which of the 12 Federal Reserve Banks issued it. For example, Federal Reserve notes issued by the Chicago Federal Reserve Bank have a capital letter C printed on them with the name of the bank indicated in the circle that surrounds the G.

Many of the new Federal Reserve notes are issued simply to replace old ones that are taken out of circulation because they are worn out or torn. However, more paper currency is demanded by the public at certain times of the year than at others. For example, each year during the Christmas shopping season Ameri­cans withdraw large amounts of cash from banks. To meet the increased demand for paper money, commercial banks withdraw additional Federal Reserve notes from their accounts with the Federal Reserve Banks. After Christmas, much of the currency is returned to commercial banks, and they find themselves with a surplus of currency on hand. They in turn redeposit that currency with the Federal Reserve Banks.

The most important function of the Fed is regulating the amount of money in circulation, which affects the cost and availability of credit and, thus, the level of business activity in the economy. Much of the remainder of this chap­ter will be devoted to an examination of how and why the Fed changes the money supply. As a first step toward understanding monetary pol­icy, let us see how banks create money.

Check Your Understanding

1.What are the primary functions of the Federal Reserve System? Which is the most important?

2.Describe the check-clearing pro­cess.

Why does the demand for paper currency change? How does the Fed
meet this changing demand?

Date: 2014-12-28; view: 915