Navigation
An overview of the central bank's structure and its role in managing the nation's money.
Imagine you have a 100, and what happens to your life savings if a central authority decides to print a trillion more of them tomorrow?
The Federal Reserve, or 'The Fed,' is the central bank of the United States. It is designed to be politically independent, meaning its leaders are appointed for long terms to prevent politicians from printing money to win elections. The structure consists of three main parts: 1) The Board of Governors (7 members based in D.C. with 14-year terms), 2) 12 Regional Reserve Banks spread across the country, and 3) The Federal Open Market Committee (FOMC). The FOMC is the 'brain' of the Fed; it meets eight times a year to decide the nation's monetary policy and set interest rates. This decentralized structure ensures that the economic needs of different regions—from the tech hubs of San Francisco to the farms of the Midwest—are considered.
Quick Check
Why are the members of the Board of Governors appointed for 14-year terms?
Answer
To ensure political independence and prevent short-term political pressure from influencing long-term economic stability.
Unlike many central banks that only care about inflation, the Fed has a Dual Mandate established by Congress: Price Stability and Maximum Employment. Price stability usually means keeping inflation around . If inflation is too high, the Fed 'tightens' the money supply. However, if they tighten too much, businesses stop hiring, and unemployment rises. Conversely, to reach maximum employment, the Fed might 'loosen' the money supply to encourage spending, which risks triggering inflation. It is a constant tug-of-war. The Fed uses the Federal Funds Rate as its primary lever to speed up or slow down the economy.
1. Imagine inflation hits . 2. The Fed decides to raise interest rates. 3. Result: Borrowing becomes expensive, consumers buy fewer cars/houses, and businesses slow down price hikes to attract customers. 4. Side effect: Because businesses are selling less, they may stop hiring, causing unemployment to tick upward.
Quick Check
If the Fed sees unemployment rising to 10% but inflation is at 0%, which part of the mandate will they likely prioritize?
Answer
Maximum Employment, likely by lowering interest rates to stimulate the economy.
How does the Fed measure the 'fuel' in the economic engine? They categorize money based on liquidity (how easily it can be spent).
When the Fed conducts Open Market Operations (buying or selling government bonds), they directly increase or decrease the amount of M1 in the banking system.
Suppose an economy has the following: - Cash in circulation: 300B - Savings accounts: 400B
1. Calculate M1: 2. Calculate M2: 3. If the Fed buys bonds and adds to checking accounts, M1 becomes and M2 becomes .
During a financial panic, people often move money from 'risky' stocks into Savings Accounts (M2) or Checking Accounts (M1). 1. If moves from a long-term investment (not in M1 or M2) into a Savings Account, M2 increases while M1 stays the same. 2. If moves from Savings to Checking, M1 increases, but M2 remains unchanged because M1 is a component of M2.
Which body within the Federal Reserve is specifically responsible for setting monetary policy and interest rates?
If you transfer from your Savings Account to your Checking Account, what happens to M1 and M2?
The Federal Reserve's 'Dual Mandate' refers to its responsibility to manage both the national debt and the tax rate.
Review Tomorrow
In 24 hours, try to explain to a friend the difference between M1 and M2, and why the Fed might want to raise interest rates if prices at the grocery store are rising too fast.
Practice Activity
Visit the official Federal Reserve website (federalreserve.gov) and find the 'Current FOMC Members' to see who is currently making these decisions.