2 Organization of the Federal Reserve System

5.800 member bunks. Together, these compo­nents make decisions that have far-reaching effects on our economy and our lives.

The Federal Reserve System — or the Fed, as it is commonly called — was established by Con­gress in 1913. Prior to that time, there were several severe financial panics during which many businesses failed and many banks were forced to close. The national banking system that existed at that time was ill-equipped to deal with such crises, and it was decided that major reforms were needed. The result of these reform efforts was the Federal Reserve Sys­tem.

The Fed consists of three levels of organization. At the very top of the organizational structure are the Board of Governors, the Federal Open Market Committee, and the Federal Advisory Council. The second level consists of 12 Federal Reserve Banks scattered throughout the United States. The third level is made up of approximately The Board of Governors, which is the central policy-making body of the Federal Reserve Sys­tem, is responsible for supervising the overall operation of the Fed and for formulating and carrying out monetary policy. It consists of sev­en members — prominent bankers, economists, and business executives —appointed by the President of the United States and confirmed by the Senate. Each member is appointed for a 14-year term and is ineligible for reappointment. The terms of the seven members are staggered so that a new member is appointed by the President every two years. The President also appoints one of the seven members as chairperson of the Board for a term of four years.

In actuality, many of the Board's members do not complete their entire 14-year terms. Many resign because of their age or to pursue other interests. Although Board members can be removed for not doing their job satisfactori­ly, none have ever met this fate. The average term completed by Board members is between five and six years.

The members of the Board of Governors are seven of the most powerful people in the nation in terms of the effect their decisions have on the economy. It is extremely important that their decisions not be influenced by partisan politics. The creators of the Federal Reserve were aware of this danger and took precautions to prevent this from happening. For one thing, Board decisions do not have to be approved by the President or Congress. In addition, because Board members serve long terms and are ineli­gible for reappointment, they do not have to fear losing their jobs because a new President has been elected. As a result, the Board of Gov­ernors remains relatively independent of poli­tics.

Federal Open Market Committee

The Federal Open Market Committee is made up of 12 members — the seven members of the Board of Governors and five presidents of Fed­eral Reserve Banks. This committee is respon­sible for directing the buying and selling of gov­ernment securities in the open market in order to influence interest rates and the availability of credit. We will discuss the activities of the

Open Market Committee in more detail later in die chapter.

Federal Advisory Council

The Federal Advisory Council consists of 12 commercial bankers, with one member select­ed by each of the 12 Federal Reserve Banks. As the name implies, the duties of this council are strictly advisor. It meets periodically with the Board of Governors to report on general busi­ness conditions throughout the nation and to give the Board advice about future banking pol­icy. Although this council performs an impor­tant service by providing a link between bank­ers and the Board, in reality it has virtually no power and little impact on the way the Fed carries out its day-to-day activities.

The Federal Reserve Banks

The 1913 Federal Reserve Act divided the United States into 12 districts and established a separate Federal Reserve Bank for each district. One reason for this move was that the framers of the Act feared a centralized banking authority. Although other nations already had centralized their banking operations (the Bank of England, for example, was founded in 1694), Americans did not wish to place all their banks under one central power.

The map in Figure 12-2 shows the bound­aries of each of the 12 districts. The Federal Reserve Banks are located in Boston, New York, Philadelphia, Cleveland, Richmond, At­lanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. Some of the 12 Federal Reserve Banks have branch offices so that transactions between the Federal Reserve Banks and member banks can be carried out more speedily. The activities of the 12 Federal Reserve Banks are coordinated, by the Board of Governors, although the Board may allow indi­vidual Federal Reserve Banks to adopt policies designed to deal with special economic condi­tions existing within their districts.

The Federal Reserve Banks do not deal directly with the public. You cannot open an account or cash a check &t a Federal Reserve Bank. They are "bankers' banks" that deal only with financial institutions and the government. Each Federal Reserve Bank is owned by the member commercial banks in its district, which are required to buy shares of stock in their Federal Reserve Bank when they become members of the Fed. Although they are privately owned, the primary objective of the Federal Reserve Banks is to carry out the monetary policies established by the Board of Governors. In fact, most of the earnings of the Federal Reserve Banks are returned to the U.S. Treasury each year.

Member Banks

As you learned in the previous chapter, all national banks are required to become mem­bers of the Fed but state banks can choose to join or not to join. Currently, there are approx­imately 5,800 member banks. This figure includes all of the approximately 4,750 national banks plus about 1,050 state banks. The remain­ing 8,600 or so state banks are not members.

Prior to 1980, nonmember state banks were not subject to controls by the Fed. This is one of the major reasons they chose not to join. Instead, they were subject to less strict controls by state agencies. However, the 1980 changes in the banking laws eliminated much of the distinction between member and nonmember banks. Today, even state banks that are not members of the Fed must keep reserves equal to those required of member banks. In addi­tion, nonmember banks as well as member banks have access to Fed services, such as the Fed's check-clearing facilities and computer­ized funds transfer system. Thus, there is little reason today for state banks to join the Fed.

Check Your Understanding

1. How is the Federal Reserve System organized?

2. What functions are performed by the Board of Governors? The Federal Open Market Committee? The Feder­al Advisory Council?

3. How are Federal Reserve Banks distributed? What functions do they serve?

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?