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Your Money and the Federal Reserve System
Federal Reserve System of Minneapolis
Grade Levels: 10, 11, 12
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YourMoney and the FedmalReserve System
.i ,
YourMorIeya~zdthe FederalReserve System
FederalReserveBank of Minneapolis
FirstPrintingJuly 1970
RevisedDecember 1971
RevisedJanuary 1973
Revised1976
Revised1978
Revised1980
Revised1982
Some thingsnwer change.Primitivecultureshad many of the
same needs we have totiy-fw what we now call “money.”
~ey neededa way to bade the thingsthey mudeor raised or
huntedfwother thingsthey wanted.~ey neededa way to measurethe
valueof things.~ey neededa way tosave or storethe valueof what they
produced,so thatvalue couldbe used or achanged lateron. ~ey needed
money.
We’restillworkingon betterways to p~orm thesefinctions—
makingmoneywork as a mediumof mchnge, a measureof value,and a
means of storingvaluefor fiture use.
WithoutMoney WeMust Bar&
Theancestorof moneywas the barter system—whereone product or servicewas
exchangedforanother.Barterwould be a cumbersomewayof doing businessintoday’s
world.For example,how many cows would an automobile dealer take in exchange
fora car?Perhapsthecarmanufacturerwouldpreferhorses.Thenthedealerwouldhaveto
exchangecowstaken in tradefor horses.Ourancestorsfound theywerewastinga lot of
timearrangingtrades,timethatcould betterbespentproducingthings—sotheysoughta
bettermethod of exchange.
EarluForms of Moneu
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As an improvementon barter,certain popular,measurable commodities came to be used as mediums of exchange.Standard itemssuch as salt,tea,pelts,beads,
cattle,or grain had general acceptance in trade and
were used as money.Thus,a person could “buy”
something with a widely accepted commodity.And
thesellerInturn could tradethatsamecommodityfor
his or her own purchases.This systemwas an improvementover direct barter but was still cumbersome.Besides,notall commoditiescould be stored
for future use.
Coins Sme As Money
Primitiveman began to use metals—particularlygold
and silver—inplace of commodities as formsof money.
Metals provided a measureof value and were easily
storedor saved for future use. Metal could also be
formedintocoinsortokensofdifferentsizeswithdifferent
values.Earlycoins carried likenessesof kings and emperors,just as modern coins carry images of political
leaders.
Disadvantagesof Coin
While coins possessthe basic qualitiesthat people requireof money,
they havetwo major faults,They are not convenientto carry in large
amountsand,moreimportant,thesupplyof coins isIimitedtothe metals
available.With coins,the money supply depends on random forces
such as silverand gold discoveriesratherthan on the needs of
commerce,industry,and agricultural production.Thus,moneydeveloped two newrequirements—ithad to be easyto carryand the supply
had to be flexibleto keep pace with changing economic needs.The
usefulnessof moneybecamemoreimportantthan the substancefrom
which it was made.
ModernFm
of Money
Money today consists of coins, paper currency,and transactionaccount deposits(fundsin checking accounts,sharedraftaccounts,and NOWaccounts).
We use coins to deposit in vending machines,for small purchases,or to make
change. Papermoney is used to pay for things that have higher prices.We’re
moreapt to use funds in transactionaccounts to settle businessdealings.
Still,thereareinherentproblemswiththesemodernformsof money.They
still require physical movementof cash or checks from buyersto the sellers.
That’soften inconvenient,and it’s costly. It costs a great deal to process and
collectthe morethan 30 billion checksthatAmericanscurrentlywriteeachyear.
Now we’re beginning to make electronic transfersof money.Electronic transfersdon’t requirethe physicalmovementof cash or checks.Whena
buyer makesa purchase,funds are transferredby keypunched entriesat a
computer unit ratherthan by writing a check.As electronic paymentsystems
becomemoresophisticatedand widely used,there’11
be lessneedto carrycash
or to process checks to pay for purchases.
Modern forms of money possessthe three qualities which our ancestors sought and which we need today—amedium of exchange,a measureof
value,and a meansto saveor store purchasing power.Moreover,the development of our central banking systemallows the supply of moneyto expand or
contractto meetthe changing needs of our economy.
CommeYciulBankingBe@ns
Although archeologistshave uncoveredstone tablets that apparentlyservedas loan
contractsin ancient Babylon,modern day banking probably had its start in England.
Goldsmithsstored gold and coins for customersas a sideline to their principal trade.
Smithsaccepted customers’gold fordepositand issuedreceiptsforthe amount.Intime,
depositorsof gold found they could settledebts by transferringgold receipts insteadof
gold itself—itwas easierand also safer.So peopletransferredgold receiptsin much the
samewaywe pay with checks writtenon our deposit in a bank.
Goldsmithssoon discoveredthat part of the money leftwith them was never
withdrawn.Theycould loan it to other personswho would repay later,with interest.
Furthermore,the borrowersfound it convenientto accept receiptsforthe amountof their
loansratherthan actualgold;the receiptswereusedas moneyandwerelighterandsafer.
Thischange in the roleof goldsmiths,fromcustodiansto lenders,markedthe beginning
of commercialbanking as we know it today.
Can FinancialInstitutionsInfluenceOurMoney
. Supply?
For mostof us the particular kind of moneywe have—beit coin, currency,or
transactionaccount deposits—isnot as importantas how much we haveto
spend.Our personalmoneysupply is the total of coin and currencywe havein
our pockets plus the balance we have in a transactionaccount at a financial
institution.
Likewise,our nation’smoneysupply is the total of everyone’smoney—
currency,coin, and transactionaccounts.All of this money is availablefor
spending by someone.
Financialinstitutionsadvertisethattheypay intereston moneyand lend
money,also at interest.By granting loans,financial institutions increasethe
purchasing powerof individual borrowersby providing them with additional
funds which must be paid back later.The personwho saves,conversely,
postponesspending and storesthat purchasing powerfor anotherday.
A general increasein loansaffectsour economy by adding to the total
amount of moneyavailablefor spending.
WeBtiow To Buy
Moneyisborrowedformanypurposes—suchasto buyacarora home,
to payfor medical services,to purchaserawmaterialsfor manufacturing,to pay employees,or to stock inventories.
When individuals,businesses,and governmentsborrowmore
money,theyincreasetheirpurchasingpoweraswell asthedemandfor
goods and services in the economy.
More lending by financial institutionsmeansmoredemandfor
goods and servicesintheeconomy;lesslending meanslessdemand.
Inthe UnitedStates,the FederalReserveSystemhasthe power
to encourageor discourage lending by financial institutions.Thus it
influencesthe levelof spending and production in our economy.
EarlyProblemsof OurMoney and BankingSystm
Beforetherewas a FederalReserveSystem,the United States’money systemdid not
alwaysservetheeconomywell.Suppliesof moneycould notreadilyadjustin responseto
1
changes in businessactivity.
As a result,banksoftenfound themselvesshortofcurrency.Bank depositorshad
a legal rightto withdrawtheir money in the form of currencyor coin if they chose,and
banks provided for ordinarywithdrawalsby retaining part of their total deposits as
reserves.Thesereserveswerepartlycurrencyandcoin and partlydepositsinotherbanks
which could be exchangedfor currency.
Sometimesdemand for currencywas greaterthan the supply of moneykept on
handbya bank.Thenthebanksought currencybydrawingon itsdeposits inotherbanks
or by selling bank assets.Such action all too frequentlycaused a chain reaction of
currencyshortages in a number of banks.
Banks unableto meetunusualdepositor requestsfor currency“failed” and were
forcedto close.Inmanyinstances,banksthatfailedwereperfectlysound,andtheirassets
could have been converted into currency if they had had enough time. Unfortunately,
panickydepositors lostconfidence in the banks and would not postponetheir demand
for currency.Bank closings brought on periodsof economic depressioncalled “money
panics.”
In responseto the 1907 panic,Congressbegan a thorough study of our money
system.Thestudyfound that nearlyallcountrieswhosecurrencysupplycould expandor
contract in responseto depositor demands (an “elastic” currency)had some form of
centralbank.Thesecentralbankshadthe powertoissuecurrencyinthequantityneeded.
As a resultof this and other studies,the United StatesCongress passedthe Federal
ReserveAct in 1913,creating the FederalReserveSystem.
Minnesota Historical Society
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What1sthe FederalReserve System?
Since 1913,the Federal ReserveSystemhas functioned as the
centralbankof the UnitedStates.Itschiefjob is monetarypolicy—to
managethe supply of moneyand credit in the best interestsof our
nationaleconomy.
Foundersof the FederalReserveSystemwere concerned
thatthe powerto controlthe moneysupplyshould notservepolitical
interests.Such power mustserveall citizens.
The Systemis composed of a central Board of Governors
locatedinWashington,DC,and 12 regionalReserveBanksserving
geographicdistricts.DistrictBank presidentsworkwiththe Boardof
Governorsto determinecentral bank policy.Thisassuresthat each
region’sinterestsare representedwhen decisions are made at the
national level.
TheBoard of GovernorsoverseesReserveBank operations
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and issuesbanking regulations.The Board’s seven membersare
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appointedbythe Presidentand confirmedbytheSenate.Theyserve
14-yearterms.
*
Each district ReserveBank is governed by nine directors:
three bankers,three representativesof business,commerce,or *
agriculture,and three membersselected to representthe general
public.
All nationalbanksare requiredto be membersofthe Fed
ReserveSystem.Statecharteredbankscan be membersbychol
All memberbanks participate in the election of their district Ba
board of directors.
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MonetaryPoliq Function
As our central bank,the FederalReserveSystem
managesthe moneysupplyofthe U.S.by influencing the lending activityof financial institutions,
which in turn affects the levelof spending and
production in our economy.This is called monetary policy.
Whenfinancial institutionsmake moreor
fewerloans,they affect the amount of spendable
moneyall of us have;thus the FederalReserve
System’sinfluenceon lending is an importanttool
of monetarypolicy.
Approximatelyonceeach month,thepresidentsof the regionalReserveBanksmeetwiththe
Board of Governorsto discuss and act on monetary policy. Fiveof the presidents,who serveon a
rotatingbasis,and the Board of Governorsconstitutethe FederalOpen MarketCommittee(FOMC)
which is the policy making body that sets guidelinesfor managing the availabilityof moneyand
credit on a day-to-daybasis.
Bystimulatingordiscouragingdemandfor
goods and services,the FOMCcan moderatethe
degree of inflationor recessionin our economy.
Forexample,if inflationthreatens,the FOMC can
follow a “restrictive”monetarypolicy which will
make it harderfor consumers,businesses,and
governmentsto borrowmoneyto buy moregoods
and services.Thisaction to lessenthe demandfor
goods lessensinflationarypressureon prices.
On the other hand, if the economy is in a
recession,theFOMCmayactto increasethemoney
supply—toincreasedemand and thus stimulate
the economy.
Developingmonetarypolicy isanongoing
‘process.It requirescontinuous monitoring of the
economy.Each time the FOMC meets,members
examinesuch factors as the level of unemploymerit,therateof inflation,interestrates,the levelsof
reservesin thefinancialsystem,the overallmoney
supply,plus current saving and spending. They
also look at internationaltrade and international
moneyflowsand exchangerates.Afterthis review,
FOMCmembersdecide the best monetarypolicy
to follow to improvethe strengthand efficiencyof
our economy.
This ongoing process is repeatedevery
four to sixweeksand is directed towardfour main
objectives:FULL EMPLOYMENT,ECONOMIC
GROWTH,STABLEPRICES,and a satisfactory
BAIANCE OF PAYMENTSin our international
trade.Understandably,monetarypolicy cannot
serveall these objectives at the same time, and
sometimeshard choices and compromisesmust
be made.Nevertheless,FOMC membersstriveto
set policy that will help achievethese combined
objectives.
FOMC
Marketbrightensas the Fed
~- credit
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makes moves to loosen
The pensive
to b
NEW YORK, N.Y:JAP) ~...-,
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stock market got ott to a are~ly
start this week, but then staged a
strong comeback amid hopes that
the
...—Federal Reserve wouldrelax its
since early April at IO-. lv.
credit policies.
The market picture began to
The net result was a modest debrighten Thursday, however, when
cline in continued sluggishtrading.
New York State’s
Ar
avwdcomptroller,
to co
&he ~*----7
The Dow Jones average of...30industriaIs, down 34 points In L.,e
week’s first three sessions, had cut
its loss to only 5.39by yesterday’s
close.
it throughmid-Dec~moer.
After ~ursdays close, weel ‘—..
COMPARABLYMINORdeclines
were posted by Standard &Poor’s Federal Reserve statistics shov’500-stock index, off .24 at 85.95, continued lag in the nation’s m1
and the New York StockExchange
composite index,down .21at 45.49.
cash got a warm reception o
Losers outnumbered g a i n e rs
because of i~ }mpti(
1,109to 605amongthe 1,999Issues Street
for Federal Reserve pohcy.
traded on the BigBoard.
Tf the moneY supply was
A gloomy mood was set Monday
, “,~ . . . in~ when Treasury secreta~
:’...
..,arned that the gap
.:~=eand
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a
w
ge
Mon&y Poliq. . . Influencingthe Supply
~Money and Credit
FederalReservemonetarypolicy influenceslending byfinancial institutions—andthus our moneysupply—byinfluencing
the reservesof financial institutions.
As a resultof the passageof the MonetaryControlAct
of 1980,all depository institutionswhich offertransaction
accounts(commercialbanks,credit unions,savingsand loan
associations,and savingsbanks)arerequiredto hold reserves
as set by the Federal Reserve.
Wehaveseenthatexpandedloansbyfinancial institutions increasethe moneysupply—byadding to transaction
accounts in those institutions.And becausereservesareonly
a fractionof deposits,each dollar of newreservescan support
severaldollarsof newdeposits(andnewloans)inthefinancial
system.
Therefore,by increasingor decreasing the amount
of reservesin thefinancial system,the FederalReservealters
thepotentialvolumeoftransactiondepositsthatcanbecreated
by lending.
The FederalReserveaffects reservesin three ways:
first,as stated above,it sets the percentageof deposits that
financial institutionsare requiredto maintainas reserves.
If they are permittedto maintaina smallerpercentageof their
deposits as reserves,it meansthat each reservedollar can
support moredeposit dollars.Financialinstitutionscan make
more loans and createdeposits until the new reserveratio is
reached.
Raisingthe percentageof required reservesmeans
thateach reservedollar can support fewerdeposits;deposits
will haveto be reduced to meetthe new ratioof reservesto
deposits.To do so, loan volume will haveto be reduced.
Second,each ReserveBank can lend funds to financial institutionsand thus increasereserves.The FederalReservedeterminesthe discount (interest)ratewhich must be
paid for such loans.It usuallygrants loans when financial
institutionsare faced with temporaryor unusual operating
needs.
Third,the FederalReservemostfrequentlyadjuststhe
levelof reservesby buying or selling US. governmentsecurities on the open market—knownas open market operations.
OpenMarket Operations
If the Federal Reservewishesto increasereserves,it buys
governmentsecuritiesand gives Federal Reservechecks to
sellers.Sellersdeposit these checks in their financial institutions which in turn deposit the checks with the Federal Reserve.To pay the checks,the Federal Reserveincreasesthe
accounts of depositing institutions.Thus,reservesin the financial systemare increased.
To lowerthe levelof reserves,the FederalReservesells
governmentsecuritiesthat it owns,normallyto established
securitydealers.Dealerspayfor securitieswith checks drawn
on financial institutions.To collect these checks,the Federal
Reservechargesthe accountsofthe institutions.Thisreduces
reservesin the financial system.
The FederalOpen Market Committeesetsguidelines
and objectivesfor open marketoperations.Actual day-to-day
purchasesor salesof securitiesaremadethroughthe Federal
ReserveBank of New York.
17zeFederalReserve Prwides Currencyand Coin
FederalReserveBanks also providecurrencyand coin forfinancial institutions.Whena
financial institution needs additional currencyand coin to supply its customers,it may
orderfrom the ReserveBank and pay by drawing on its account at the ReserveBank,
Whena financial institutionaccumulatesmorecurrencyor coin than it needs,it can ship
itsexcessto the ReserveBank and get credit in its account.
In orderto maintainthe quality of our coin and currencysupplies,ReserveBanks
removefrom circulation unfit or obsolete currencyand coin. New coin is obtained from
the U.S.mintsand newcurrencyfromthe Bureauof Engravingand Printingin Washington, DC.The ReserveBanks funnel new money into the economy as individuals and
businessesneed cash.
FederalReserve PaymentServices
Americanstoday are writing over 30 billion checks annually.
Thesechecks (including sharedraftswritten on credit union
sharedraft accounts and negotiable orders of withdrawal
writtenon NOWaccounts)areorders by depositorsdrawnon
financial institutionsto transferfunds.Theymaypayfor goods
and servicesbought locally or in other parts of the country.A
person receivinga check wants it presentedfor paymentas
quicklyas possible,becauseanydelaywill postponethe time
when moneyrepresentedby the check can be used.
Whena check iswritteninor nearthecommunityofthe
institutionon which it is drawn,presentationfor payment is
direct—localinstitutionsjust exchangechecks among themselves.It’sestimated,however,thatmorethan halfof allchecks
leavethe local community.Financial institutionsreceiving
checks drawn on distant institutionsfind it costly and inconvenientto returnsuch checks directly for payment.instead,they mayuse check collection servicesat district Federal ReserveBanks where checks for manyfinancial institutions are cleared at the same time.Someare presentedby
financial institutions,some are presentedby the Treasuryof
theUnitedStatesorothergovernmentagencies,and someare
receivedfrom other Federal ReserveBanks.
PaymentServicesDepartmentsatthe ReserveBanks
use modern electronic equipment to sort and deliver checks
for paymentasquickly as possible.Theysendchecks directly
tofinancial institutionslocatedintheirown reservedistrictand
send checks drawn on institutionsin other districts directlyto
the Federal ReserveBank serving those institutions.The
receivingReserveBank,in turn,forwardschecks to the financial institutionsin itsdistrict.ReserveBanksgivedepositcredit
forthe checks receivedand mustobtain paymentfrom financial institutionson which checks are drawn.For payment,the
ReserveBank may charge the account of the paying institution directly,or through another financial institution.
In addition to paymentsmade by check, billions of
dollars circulate electronicallythroughout the United States
economyeach day. Many of these “electronic payments”are
transferredoverthe Fed’s interbankcommunication system.
Thatsystemallows a business or an individual to make a
payment(usuallylarge)from an account in a financial institution to someone else anywherein the nation simply by
instructingthe financial institutionto transferthe funds.The
financial institutionthen initiatesthe paymentthrough a telephonecall ora computermessagedirectlyto computersatthe
FederalReserveBank.Therethis payment messageis recorded and forwardedto itsdestinationina matterof minutes.
TheFedalsooperatesa numberofautomatedclearinghouses(ACHS)through which recurring paymentssuch as
payrollsand Social Security paymentsare added electronicallyto the accounts of the recipientsin theirfinancial institutions.
/
.
Who Pays the Cost of Operating
the FederalReserve?
When FederalReserveBankswereestablishedby Congress
to performcentral bank functions in the public interest,provisionwasmadeto shieldthemfrompolitical influence.Unlike
traditionalfederalagencies,the FederalReservereceivesno
budgetappropriationsfromCongress.InsteadReserveBanks
earn their own income from:
Cl intereston governmentsecuritiespurchased and
held by the FederalReserveSystem,
Cl fees receivedfrom financial institutionsusing
FederalReserveservices,and
Cl interestthey receiveon loans granted to financial
institutions.
At the end of each year,ReserveBanks returnto the
U.S.Treasuryall earnings in excessof those used to pay for
ReserveBank operations.In recentyears,the expenseof
operating ReserveBanks has been lessthan 9??0 of total
earnings,Mostofthe remainingearningsaretransferredtothe
Treasuryeach year.
Services. . . the FederalReserve Serves the Government
Ourgovernmentbuysgoods and services—alotof them—thesameasbusinesses
and individuals.So,the governmentneeds banking servicesto assist its transactions.It usesthe servicesof FederalReserveBanksmuch as privatebusinesses
use servicesof commercial banks.
All checks drawn on the Treasuryof the United Statesare paid at Federal
ReserveBanks.Eachyear,billions of dollarsaredeposited byvariousgovernment
agenciessuch as the InternalRevenueService—thenbillions of dollars in checks
arewrittenagainst these deposits.Since the governmentranks as the country’s
biggest business,handling its bank account is an importanttask.
Sometimesthe governmentborrowsto haveenough moneyfor itspayrolls,
purchases,andotherexpenses.Toborrowmoney,theTreasurysellsitssecuritiesto
individuals,banks,dealers,and other investors.TreasuryBills are short-term
securitiesmaturing in three months,six months,or one year.TreasuryNotes are
payablein one to ten years,and TreasuryBonds are payableat maturitiesof ten
yearsor longer.U.S.Savings Bonds, sold primarilyto individuals,also represent
Treasuryborrowing.
Whenthe Treasuryborrowsmoneyor pays off maturingdebt, Federal
ReserveBanks performthese transactionsfor their districts,providing a vital link
betweenthe public and the Treasury.
Money alone mnnotproducethe thingswe want and need; it
an onlypayfor them.Pricesinoureconomydependon boththesupplyof
money and the ability to producegoods and services.If more money is
availablewithoutan increaseinprodud”on,~“cesgo up.I’fmoregoodsand
servicesare avaibble withoutan increasein the moneysupply,~“cesgo
duwn.~us prudentmanagementof our moneysupplyis a vitalresponsibility.
Money to% is an acceptablemediumof achange, a measure
of valuefwbuyerand seller,and a meansofstm”ngvaluefwfutire use.
Futureimprovementsin our money systemwill r$ect changes in
technologysuchas electronicmoneyand,hop+lly, a betterunderstanding
$ how our economy works.