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The primary motivation for creating the Federal Reserve was to address banking panics (bank runs). The Federal Reserve briefly describes the circumstances that led to its creation, the purpose for creating it, and functions of the system in The Federal Reserve in Plain English:^[12]

"Just before the founding of the Federal Reserve, the nation was plagued with financial crises. At times, these crises led to “panics,” in which people raced to their banks to withdraw their deposits. 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."

The purpose and functions of the Federal Reserve include:^[12][13]

• to address banking panics (bank runs)
• to serve as the central bank for the United States
• to strike a balance between private interests of banks and the centralized responsibility of government

• supervising and regulating banking institutions
• protect the credit rights of consumers

• to manage the nation's money supply through monetary policy

• maximum employment
• stable prices
• moderate long-term interest rates

• maintain the stability of the financial system and containing systemic risk in financial markets
• providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system
• national functions

• facilitate the exchange of payments among regions
• strengthen U.S. standing in the world economy

• regional functions within the nation

• to be responsive to local liquidity needs

[edit] Addressing the problem of bank panics

Further information: bank run, fractional-reserve banking, and money creation

Bank runs occur because banking systems are usually fractional reserve lending institutions and do not have enough cash in reserves to give to all of their depositors simultaneously. Bank runs can lead to a multitude of social and economic problems. The Federal Reserve was designed as an attempt to prevent this from occurring.

How the Federal Reserve addresses the problem of bank panics is described in The Federal Reserve System - Purposes and Functions:^[14]

"To address these problems, Congress gave the Federal Reserve System the authority to establish a nationwide check-clearing system. The System, then, was to provide not only an elastic currency—that is, a currency that would expand or shrink in amount as economic conditions warranted— but also an efficient and equitable check-collection system."

[edit] Lender of last resort

The Federal Reserve has the authority and financial resources to act as “lender of last resort” by extending credit to depository institutions or to other entities in unusual circumstances involving a national or regional emergency, where failure to obtain credit would have a severe adverse impact on the economy.^[15]

Through its discount and credit operations, Reserve Banks provide liquidity to banks to meet short-term needs stemming from seasonal fluctuations in deposits or unexpected withdrawals. Longer term liquidity may also be provided in exceptional circumstances. The rate the Fed charges banks for these loans is the discount rate (officially the primary credit rate).

In making these loans, the Fed serves as a buffer against unexpected day-to-day fluctuations in reserve demand and supply. This contributes to the effective functioning of the banking system, alleviates pressure in the reserves market and reduces the extent of unexpected movements in the interest rates.^[16]

[edit] Central bank

In its role as the central bank of the United States, the Fed serves as a banker's bank and as the government's bank. As the banker's bank, it helps to assure the safety and efficiency of the payments system. As the government's bank, or fiscal agent, the Fed processes a variety of financial transactions involving trillions of dollars. Just as an individual might keep an account at a bank, the U.S. Treasury keeps a checking account with the Federal Reserve through which incoming federal tax deposits and outgoing government payments are handled. As part of this service relationship, the Fed sells and redeems U.S. government securities such as savings bonds and Treasury bills, notes and bonds. It also issues the nation's coin and paper currency. The U.S. Treasury, through its Bureau of the Mint and Bureau of Engraving and Printing, actually produces the nation's cash supply; the Fed Banks then distribute it to financial institutions.^[17]

[edit] Federal funds

Main article: Federal funds

Federal funds are the reserve balances that private banks keep at their local Federal Reserve Bank.^[18][19] These reserve balances are the "reserves" in "federal reserve", hence the name of the system. The purpose of keeping funds at a Federal Reserve Bank is to have a mechanism through which private banks can lend funds to one another. This market for funds plays an important role in the Federal Reserve System as it is what inspired the name of the system and it is what is used as the basis for monetary policy. Monetary policy works by influencing how much money the private banks charge each other for the loaning of these funds.

[edit] Balance between private banks and responsibility of government

Private banks are regulated by the government. This means that there are some restrictions on what private banks are allowed to do. The Federal Reserve is the specific part of government that regulates the private banks.

[edit] Government regulation and supervision

The Board of Governors is the part of the Federal Reserve System that is responsible for supervising the private banks. How the system is regulated is described by the Federal Reserve:^[14]

"The Board also plays a major role in the supervision and regulation of the U.S. banking system. It has supervisory responsibilities for state-chartered banks that are members of the Federal Reserve System, bank holding companies (companies that control banks), the foreign activities of member banks, the U.S. activities of foreign banks, and Edge Act and agreement corporations (limited-purpose institutions that engage in a foreign banking business). The Board and, under delegated authority, the Federal Reserve Banks, supervise approximately 900 state member banks and 5,000 bank holding companies. Other federal agencies also serve as the primary federal supervisors of commercial banks; the Office of the Comptroller of the Currency supervises national banks, and the Federal Deposit Insurance Corporation supervises state banks that are not members of the Federal Reserve System.

"Some regulations issued by the Board apply to the entire banking industry, whereas others apply only to member banks, that is, state banks that have chosen to join the Federal Reserve System and national banks, which by law must be members of the System. The Board also issues regulations to carry out major federal laws governing consumer credit protection, such as the Truth in Lending, Equal Credit Opportunity, and Home Mortgage Disclosure Acts. Many of these consumer protection regulations apply to various lenders outside the banking industry as well as to banks.

"Members of the Board of Governors are in continual contact with other policy makers in government. They frequently testify before congressional committees on the economy, monetary policy, banking supervision and regulation, consumer credit protection, financial markets, and other matters."

"The Board has regular contact with members of the President’s Council of Economic Advisers and other key economic officials. The Chairman also meets from time to time with the President of the United States and has regular meetings with the Secretary of the Treasury. The Chairman has formal responsibilities in the international arena as well."

Tools of monetary policy

There are three main tools of monetary policy that the Federal Reserve uses to influence the amount of reserves in private banks:^[34]

1. open market operations - purchases and sales of U.S. Treasury and federal agency securities--the Federal Reserve's principal tool for implementing monetary policy. The Federal Reserve's objective for open market operations has varied over the years. During the 1980s, the focus gradually shifted toward attaining a specified level of the federal funds rate (the rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed), a process that was largely complete by the end of the decade.^[37]
2. discount rate - the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility--the discount window.^[38]
3. reserve requirements - the amount of funds that a depository institution must hold in reserve against specified deposit liabilities.^[39]

In order to address problems related to the subprime mortgage crisis, two new facilities have been created. The first new tool, called the Term Auction Facility, was added on December 12, 2007. It was first announced as a temporary tool^[40] but there have been suggestions that this new tool may remain in place for a prolonged period of time.^[41] Creation of the second new tool, called the Term Securities Lending Facility, was announced on March 11, 2008.^[42] The main difference between these 2 facilities is that the Term Auction Facility is used to inject cash into the banking system whereas the Term Securities Lending Facility is used to inject treasury securities into the banking system.^[43]

[edit] Open market operations

Further information: open market operations, money creation, and seignorage

Open market operations put money in and take money out of the banking system. This is done through the sale and purchase of U.S. government treasury securities. When the U.S. government sells securities, it gets money from the banks and the banks get a piece of paper (I.O.U.) that says the U.S. government owes the bank money. This drains money from the banks. When the U.S. government buys securities, it gives money to the banks and the banks give the I.O.U. back to the U.S. government. This puts money back into the banks. The Federal Reserve education website describes open market operations as follows:^[35]

'Open market operations involve the buying and selling of U.S. government securities (federal agency and mortgage-backed). The term "open market" means that the Fed doesn’t decide on its own which securities dealers it will do business with on a particular day. Rather, the choice emerges from an "open market" in which the various securities dealers that the Fed does business with—the primary dealers—compete on the basis of price. Open market operations are flexible and thus, the most frequently used tool of monetary policy.

'Open market operations are the primary tool used to regulate the supply of bank reserves. This tool consists of Federal Reserve purchases and sales of financial instruments, usually securities issued by the U.S. Treasury, Federal agencies and government-sponsored enterprises. Open market operations are carried out by the Domestic Trading Desk of the Federal Reserve Bank of New York under direction from the FOMC. The transactions are undertaken with primary dealers.

'The Fed’s goal in trading the securities is to affect the federal funds rate, the rate at which banks borrow reserves from each other. When the Fed wants to increase reserves, it buys securities and pays for them by making a deposit to the account maintained at the Fed by the primary dealer’s bank. When the Fed wants to reduce reserves, it sells securities and collects from those accounts. Most days, the Fed does not want to increase or decrease reserves permanently so it usually engages in transactions reversed within a day or two. That means that a reserve injection today could be withdrawn tomorrow morning, only to be renewed at some level several hours later. These short-term transactions are called repurchase agreements (repos) – the dealer sells the Fed a security and agrees to buy it back at a later date.'

A simpler description is described in The Federal Reserve in Plain English:^[12]

"How do open market operations actually work? Currently, the FOMC establishes a target for the federal funds rate (the rate banks charge each other for overnight loans). Open market purchases of government securities increase the amount of reserve funds that banks have available to lend, which puts downward pressure on the federal funds rate. Sales of government securities do just the opposite—they shrink the reserve funds available to lend and tend to raise the funds rate.

By targeting the federal funds rate, the FOMC seeks to provide the monetary stimulus required to foster a healthy economy. After each FOMC meeting, the funds rate target is announced to the public."

[edit] Repurchase agreements

Further information: repurchase agreement

To smooth temporary or cyclical changes in the monetary supply, the desk engages in repurchase agreements (repos) with its primary dealers. Repos are essentially secured, short-term lending by the Fed. On the day of the transaction, the Fed deposits money in a primary dealer’s reserve account, and receives the promised securities as collateral. When the transaction matures, the process unwinds: the Fed returns the collateral and charges the primary dealer’s reserve account for the principal and accrued interest. The term of the repo (the time between settlement and maturity) can vary from 1 day (called an overnight repo) to 65 days.^[44]

[edit] Federal funds rate and discount rate

Further information: federal funds rate and discount rate

The Federal Reserve System implements monetary policy largely by targeting the federal funds rate. This is the rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed. This rate is actually determined by the market and is not explicitly mandated by the Fed. The Fed therefore tries to align the effective federal funds rate with the targeted rate by adding or subtracting from the money supply through open market operations. The late economist Milton Friedman consistently criticized this reverse method of controlling inflation by seeking an ideal interest rate and enforcing it through affecting the money supply since nowhere in the widely accepted money supply equation are interest rates found.^[45]

The Federal Reserve System also directly sets the "discount rate", which is the interest rate that banks pay the Fed to borrow directly from it. This rate is generally set at a rate close to 100 points above the target federal funds rate. The idea is to encourage banks to seek alternative funding before using the "discount rate" option.^[46]

Both of these rates influence the prime rate which is usually about 3 percentage points higher than the federal funds rate.

Lower interest rates stimulate economic activity by lowering the cost of borrowing, making it easier for consumers and businesses to buy and build, but at the cost of promoting the expansion of the money supply and thus greater inflation. Higher interest rates slow the economy by increasing the cost of borrowing. (See monetary policy for a fuller explanation.)

The Federal Reserve System usually adjusts the federal funds rate by 0.25% or 0.50% at a time.

The Federal Reserve System might also attempt to use open market operations to change long-term interest rates, but its "buying power" on the market is significantly smaller than that of private institutions. The Fed can also attempt to "jawbone" the markets into moving towards the Fed's desired rates, but this is not always effective.^{[citation needed]}