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Federal Reserve System

Function

The most important duties of the Federal Reserve authorities relate primarily to the maintenance of monetary and credit conditions favorable to sound business activity in all fields—agricultural, industrial, and commercial. Among those duties are lending to member banks, open-market operations, fixing reserve requirements, establishing discount rates, and issuing regulations concerning those and other functions. In a sense, each Federal Reserve bank is best understood as a bankers' bank. Member banks use their reserve accounts with the reserve banks in much the same way that a bank depositor uses his checking account. They may deposit in the reserve accounts the checks on other banks and surplus currency received from their customers, and they may draw on the reserve for various purposes, especially to obtain currency and to pay checks drawn upon them (see clearing).

More importantly, the required reserves also enable the Federal Reserve authorities to influence the lending activities of banks. So long as a bank has reserves in excess of requirements, it can enlarge its extensions of credit; otherwise it cannot increase its extensions of credit and may be impelled to borrow additional funds. Inasmuch as the Federal Reserve authorities have power to increase or decrease the supply of excess funds, they are able to exercise considerable influence over the amount of credit that banks may extend. By controlling the credit market, the Federal Reserve System exerts a powerful influence on the nation's economic life. Federal Reserve activities designed to expand bank credit may lead to an upswing in the business cycle, which tends to lead toward inflation; conversely, a restriction of credit generally results in decreased business growth and deflation.

The principal means through which the Federal Reserve authorities influence bank reserves are open-market operations, discounts, and control over reserve requirements. Open-market purchases of securities by Federal Reserve authorities supply banks with additional reserve funds, and sales of securities diminish such funds. Through the power to discount and make advances, the Federal Reserve authorities are able to supply individual banks with additional reserve funds. They may make the funds more or less expensive for member banks by raising or lowering the discount rate. Discounts usually expand only when member banks need to borrow. Raising or lowering requirements—within the limits imposed by law on the Board of Governors—concerning the reserves that member banks maintain on deposit with the reserve banks has the effect of diminishing or enlarging the volume of funds that member banks have available for lending. Such powers directly affect the volume of member bank funds but have no immediate effect in the use of those funds.

In the field of stock market speculation the Federal Reserve authorities have a direct means of control over the use of funds, namely, through the establishment of margin requirements. Another of the important functions of the Federal Reserve System is furnishing Federal Reserve notes (now the chief element in the nation's currency) for circulation. Most economists and bankers agree that the Federal Reserve System has achieved marked improvements in American monetary and banking institutions. Its efforts to preserve liquidity in the international financial system, facilitate lending by financial institutions, and otherwise revive the economy during the mortgage and credit crisis that began in 2007 are regarded by many as having helped prevent a worse financial crisis and economic downturn that could have approached the Great Depression in severity.

Sections in this article:

The Columbia Electronic Encyclopedia, 6th ed. Copyright © 2012, Columbia University Press. All rights reserved.

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