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Federal Reserve System

money banks credit supply

Federal Reserve System, central U.S. banking authority. In 1913 Congress passed the Federal Reserve Act, dividing the country into 12 districts, each with a Federal Reserve Bank. A 7-member Board of Governors (Federal Reserve Board) in Washington, D.C., coordinates these banks, which constitute a central banking system, handling the government's transactions, coordinating and controlling commercial banks, and helping to regulate the nation's money supply. The Federal Reserve System, or Fed, is responsible directly to Congress. Its main purpose is to control the supply of money and credit through monetary policy. When business worsens, it expands the amount of money and credit, but if prices start rising too rapidly, the Fed will do all it can to reduce the supply of money and credit. The first step is to require the nation's banks to keep a larger amount of their deposits on reserve. With less money to lend, credit becomes “tight,” increasing the rate of interest. Businesses expand less rapidly, families cannot afford large purchases like houses or cars, and other forms of buying slow down. When the economy slows, the Fed reverses the process and makes more money available. The Fed possesses 2 other weapons against inflation and depression. First, it can go into the market and “buy” money, in what are called “open market operations.” Usually this money is in the form of short-term government bonds bought from insurance companies, banks, and big business firms, which are then free to invest the money they receive in exchange for the bonds. More money becomes available for loans, lowering interest rates and down payments. With a 20% reserve requirement, $1,000 million spent in the marketplace would add up to $5,000 million of new money. Second, the Fed lends money to member banks, loans called discounts. By regulating the discount rate (the interest banks pay to borrow from the Fed), the Fed encourages or discourages borrowing. Discount rates are usually tied to interest rates on the open market.

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