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Brigitte Jones

Professor Shilling

ECON 2301.4427

08 December 2007

Federal Reserve System

While attempting to establish economic stability, the Federal Reserve System was created

and maintained over the years. The Federal Reserve System consists of three parts: the Board of

Governors, twelve Reserve banks, and the Federal Open Market Committee. The three separate

parts work independently, along with the administration from Congress and the White House, to

operate successfully. The following essay will address, in depth, the FED’s along with their

responsibilities and actions.

The question that comes to mind is why the Federal Reserve was created to begin with.

Well, before it was originated, the nation flooded with financial problems which led to “panics,”

in which individuals withdrew all of the money from their bank accounts (US Federal Reserve

System 1). “A particularly severe panic in 1907 resulted in bank runs that wreaked havoc on the

fragile banking system and ultimately led Congress in 1913 to write the Federal Reserve Act.

Initially created to address these banking panics, the Federal Reserve is now charged with a

number of broader responsibilities, including fostering a sound banking system and a healthy

economy” (US Federal Reserve System 1). This establishment would be a central bank for the

entire nation; however, it was harder than imagined. Early supporters believed that there had to

be a balance between the national and regional interests (US Federal Reserve System 1). “On a

national front, the central bank had to be structured to facilitate the exchange of payments among

regions and to strengthen the U.S. standing in the world economy [and] [o]n a regional front, the
central bank had to be responsive to local liquidity needs, which could vary across regions” (US

Federal Reserve System 1). The two debates stress reasonable points. Congress though,

administers the entire Federal Reserves, setting objectives that must be followed. Each of the

Fed’s three parts - the Board of Governors, the regional Reserve banks, and the Federal Open

Market Committee – function independently of the federal government to enforce the

responsibilities of the Fed’s. One of the Fed’s primary jobs is “to serve as a lender of last resort”

(O’Sullivan/Sheffrin/Perez 290). For example, if banks need to borrow money in a financial

crisis, they can but only as “a last resort”.

Upon being created, obviously there are many important functions that must be

enforced. First, the Feds are responsible for supplying currency to the economy by working

through the banking system. “Although currency is only one component of the money supply, if

individuals prefer to hold currency rather than demand deposits, the Federal Reserve and the

banking systems will facilitate the public’s preferences” (O’Sullivan/Sheffrin/Perez 290). Next,

the Feds must provide a system of check collection and clearing. They must make the financial

transactions “work” so that when a check is written, it is cleared, and the funds become

available. Then, the Feds must hold reserves from banks and other depository institutions, as

well as, regulate them. This process is used to provide proof that the banks are complying with

rules and regulations in a safe system. Lastly, the Feds conduct monetary policy in order to

influence the level of GDP or inflation. “If the economy is operating at a level that’s “too hot” or

“too cold,” they can manipulate the money supply to fend off economic problems”

(O’Sullivan/Sheffrin/Perez 290).

Also, the structure of the Federal Reserve is broken down into three subgroups: Federal

Reserve Bank, Board of Governors of the Federal Reserve, and the Federal Open Market
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Committee (FOMC). The United States is divided into “… 12 Federal Reserve districts, each of

which has a Federal Reserve Bank” (O’Sullivan/Sheffrin/Perez 290). The district banks provide

advice on the monetary policy and act as a liaison between the banks in their districts and the Fed

(O’Sullivan/Sheffrin/Perez 290). The Board of Governors of the Federal Reserve is the true seat

of the power. It is located in Washington, D.C. and it is the seven-person governing body. All of

the seven individuals must be approved by Senate first. The FOMC is the group that decides on

the monetary policy and it consists of the members from the other part plus five of the twelve of

the regional bank presidents, but they rotate constantly.

On the other hand, what is monetary policy and why is used rather than fiscal policy,

knowing that both can be used to stabilize the economy? Well, monetary policy is “the range of

actions that influence the level of real GDP or inflation” (O’Sullivan/Sheffrin/Perez 290). In

order for monetary policy to work in stabilizing the economy, the Feds use three tools: discount

rate, reserve requirements, and open market operations. All of which help to maintain a healthy

economy and “reflect the Committee’s policy goals: easing and tightening or maintaining the

Nation’s money supply” (US Federal Reserve System 10-11). In contrast, fiscal policy is the

“changes in [government] taxes and spending that affect the level of GDP – to stabilize the

economy” (O’Sullivan/Sheffrin/Perez 212). An example of fiscal policy stabilizing the economy

is “[i]f the budget were initially balanced and the economy plunged into a recession, a budget

deficit would emerge as tax revenues fell and expenditures increased” (O’Sullivan/Sheffrin/Perez

222). To fix such problem, policy makers would either have to increase government spending or

cut taxes. However, the fiscal policy changed over many years and both inside and outside lags

limit the effectiveness of that policy. The information shows that the monetary policy is by far

more accurate; which could be why it is used as opposed to the fiscal policy.
 As for policy actions over the last two decades, those are what made a difference in the

stabilization of the economy. First, the banks held excess reserves during the Great Depression

because they were afraid that people might withdraw their money from their bank accounts.

Which caused the Feds to get “concerned about the ‘excess’ reserves and [they] raised the

reserve requirements for banks” (O’Sullivan/Sheffrin/Perez 297). Then, in 1987, the stock

market crash was a dramatic decrease in the index of the stock market. The Federal Reserve

“stood ready to provide liquidity to the economy and the financial system [and] [b]anks were

told that the Fed would let them borrow liberally” (O’Sullivan/Sheffrin/Perez 293). This even led

to a decrease in interest rates because the Feds helped so much. When the financial system was

under stress after the September eleventh incident, the Feds steeped in. They “… immediately

took numerous of steps to provide additional funds to the financial system”

(O’Sullivan/Sheffrin/Perez 294). The Feds allowed the banks to borrow more, they served as a

clearing house for checks, and they purchased government securities in the marketplace. All of

those crises were resolved because the Federal Reserve System steeped in like they were suppose

to and stabilized the economy.

As for the subprime mortgage market, the Federal Reserve System also plays a role

in that. But, before providing details, the background information is important. “The recent sharp

increases in subprime mortgage loan delinquencies and in the number of homes entering

foreclosures raise important economic, social, and regulatory issues” (Bernanke 1). Subprime

mortgage loans are loans that are made to borrowers who are perceived to have a high credit risk.

Lenders used different techniques to use the information to determine underwritten standards, set

interest rates, and manage their risks (Bernanke 1). “Claims of surprise — and even dismay —

about developments in the sub-prime mortgage sector seem unfounded” (Adelson 1). Many
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years, the credit quality had been extremely solid; however, that statement no longer remains

true. “The sharp rise in delinquencies among subprime adjustable-rate mortgages (ARMs) has

multiple causes” (Bernanke 2). Many people ignored the obvious though. “For many sub-prime

mortgage loans originated over the past two years, lenders ignored the famous ‘Three C's’ of

mortgage lending: character, capacity, and collateral” (Adelson 1). The market environment

allowed them to do so “[b]y operating at high leverage, the lenders could book profits from

origination activities without regard to the actual quality of the loans or the magnitude of the

risks that they retained” (Adelson 1). Beyond the obvious were also many warnings. Many

voices in the market expressed concerns about the mounting vulnerabilities over the past two

years including the weakening of underwriting standards, the housing bubble, housing

affordability, and the tightening of credit spreads on triple-B tranches (Adelson 2&3). “In all

cases they offered warnings and recommended caution – either explicitly or implicitly” (Adelson

3). The people just acted as if nothing was said.

Continuously, the Federal Reserve System takes action just like they do in other

situations. As for the sub-prime mortgage market, when it can to the area of disclosure, they

were responsible for “writing the regulation that implements the Truth in Lending Act (TILA),

known as Regulation Z” (Bernanke 4). This regulation ensured that the lenders provide the

borrowers with clear, accurate, and timely information about the conditions and terms of the

loans. So, the borrowers had at least a little bit of structure. The Federal Reserve also “authorized

to write rules; notably, the Home Ownership Equity Protection Act (HOPEA) gives the Board

the power to prohibit acts and practices in mortgage lending deemed ‘unfair’ or ‘deceptive’”

(Bernanke 4). The information supports the fact that the Federal Reserve System has attempted

to help. It also shows that the sub-prime is no surprise. There were many obvious signs, as well
as, warnings, but everyone overlooked them. “The Federal Reserve is currently undertaking a

thorough review of all its options under the law” (Bernanke 4). Altogether, there has been a

slowdown in economic growth. Even though, they “will do all that they can to prevent fraud and

abusive lending and to ensure that the lenders employ sound underwriting practices and make

effective disclosures to consumers” (Bernanke 6), they cannot correct everything on their own.

Moreover, “[t]he current flurry of activity to ‘do something’ about the sub-prime mortgage

situation is a day late and a dollar short … [b]oth policymakers and market participants share

responsibility for the current situation by having ignored the warnings and having failed to act

sooner” (Adelson 8). The facts are present, preventative measures should have been considered

and placed into action long before it got out of hand. “And, lastly and most importantly,

policymakers should refrain from taking drastic, ill-conceived actions that ultimately do more

harm than good by unduly reducing the availability of mortgage credit to American families”

(Adelson 8).

In conclusion, the Federal Reserve System had been created and carried out for numerous

reasons. Not only do they help maintain economic stability, but they also know what actions to

take during a financial crisis. Keep in mind, the three parts: the Board of Governors, twelve

Reserve banks, and the Federal Open Market Committee, work independently, along with the

administration from Congress and the White House, to operate successfully. This goes to show

that the Federal Reserve alone cannot function. Similar to a car, without gas it cannot move just

as without direction from Congress and the White House it cannot succeed.
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Work Cited

Adelson, Mark. “Sub-prime Surprise … Not!” Nomura Fixed Income Research. 18 Apr. 2007: 1-

15. 4 Dec. 2007 < www.nomura.com/research/s16>.

Bernanke, Ben S. “Bernanke.” Board of Governors of the US Federal Reserve System. 17 May

2007: 1-7. 29 Nov. 2007 <http://www.federalreserve.gov/newsevents/Bernanke/Bernanke

20070517a.htm>.

O’Sullivan, Arthur, Steven M. Sheffrin, and Stephen J. Perez. Macroeconomics, Principles,

Applications, and Tools. 5th ed. New Jersey: Upper Saddle River, 2007.

US Federal Reserve System. In Plain English: Making Sense of the Federal Reserve. 1-18. 29

Nov. 2007 <www.FederalReserveEducation.org>.