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Your Money and the Federal Reserve System Federal Reserve System of Minneapolis Grade Levels: 10, 11, 12 Document Type: Reference Material Description: This document may be printed. 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 r~’~ &4- ~[, 4 ‘~ -34, ~~{,flH~e4q. \ 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 -. .. —.. e- — “., 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 * and issuesbanking regulations.The Board’s seven membersare * 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. + o “* * ‘u Alaska Hawaii 12 * D 12 ● . ● . .*- ● @ 8 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 *.A ~ makes moves to loosen The pensive to b NEW YORK, N.Y:JAP) ~...-, .,..l:~ r,coV@ 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 m7if+ 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.