How the Federal Reserve Board Controls Money and Banking

What is money? Americans handle money every day of their lives, but few have any understanding of what money actually is or where it comes from. Money can be defined as a unit of account, a medium of exchange or a store of value, but this gives little idea of what the green stuff is or where it comes from.

Two Forms of Money: Currency and Demand Deposits

The first form of money is currency, more technically known as “Federal Reserve Notes.” A dollar bill actually is a note saying the Federal Reserve owes you one dollar. The dollar bill is also legal tender, which means it must be accepted as payment for goods or services.

The other form of money is demand deposits, which is sometimes called “checkbook money.” This is money that has been deposited in commercial banks and makes up the majority of all US money.

Material Value Behind Money and What is Behind Demand Deposits

Historically, banks were required to keep a store of gold or silver in reserve, in case someone came in and demanded “hard” money for his or her bank notes. On the basis of the reserves of gold or silver, banks lent many times the actual amount of their reserves. This worked well as long as both the depositor and the borrower didn’t come at the same time, demanding the bank’s demand deposits. By lending, banks actually created money because they lent far more than they actually had.

Today’s banks work much the same way, except there is no gold or silver behind the demand deposits. What is behind these demand deposits is somewhat hard to define. It consists of currency and coins, and deposits of commercial banks in the Federal Reserve. What this actually means is that it consists of the people’s faith in the Federal Reserve System.

What is the Federal Reserve Board and How Does the Fed Control Money and Banks?

So what is the Fed? How do these seven people in Washington affect the nation’s money supply? These seven people, making up the Board of Governors of the Federal Reserve System, are appointed by the President to rotating 14-year terms. They are not elected by the people, nor do the people have much control over the Fed’s decisions. Congress and the President also have little control over the Fed’s decisions. The Fed is basically an independent, semi-private, semi-public body. Yet it exercises almost complete control over the nations’s money.

The Fed does this in three ways. The first is by changing the legal reserve requirement. At present, all banks are required to keep in reserve at least 10 percent of their total amount of deposits. Suppose the Fed were to up this to 15 percent. Banks would then cut back on lending because more demand deposits would have to be kept in reserve. As loans were paid off, they would keep the money in reserve and stop lending until their reserves equaled 15 percent of their total deposits. If the Fed lowered the requirement, the opposite would take place. Banks would have “money to spare,” which would result in easy credit and more loans.

Another “tool” of the Fed is the discount rate. This is the rate of interest at which banks can borrow extra funds from the Fed. If the Fed raised the discount rate, it would discourage bank borrowing, which would decrease the amount of money banks would have to lend. A lower rate would result in banks borrowing more money, and thus having more money to lend.

The final and most often used way the Fed affects the money supply is through what is called “open market operations.” This involves the buying and selling of government bonds. For instance, the Fed decides to sell a certain amount in bonds to a private broker. The broker pays by writing a check. The Fed then presents this check to the private bank for payment. The private bank must, in turn, dig into its reserves. This reduction in reserves causes the bank to reduce the amount of lending. Again, by reversing operations, the opposite effect can be achieved. In order to encourage an increase in lending, the Fed can buy government bonds. The money it pays is then deposited into the reserve of the private bank, which means there is more money for lending purposes.

Through all this, the Fed cannot force people to borrow money. It can make it easier to borrow, thus encouraging it, but individuals and firms still have a choice as to whether or not they want to borrow. Banks also have the choice of whether or not they want to make money available for loans.

If there were no controls on the money supply, banks would lend money far beyond what they had in reserve. People would lose faith in their banks, and thus in the value of money supply.

Though the basis of money has changed over the years, its basic functions remain the same. These functions are kept under control by the Federal Reserve System.