Understanding The Federal Reserve and the U.S. Banking System
- Kimi Basamak
- Feb 5
- 4 min read
What is the Federal Reserve?
The US Federal Reserve bank, commonly known as the Fed, is the central banking system of the United States. This bank controls economic policy that shapes, changes, and controls the US economy, which guides the global economy. Although the bank is run by the US government, there are measures in place to keep political and economic goals separate, helping to keep market confidence and stability even in times of political turmoil.
The Fed is one of the most important corporations in the world, as it dictates the economic future with its control of interest, inflation, employment, and currency value. Through monetary policy, the Fed serves as the bank that all other banks rely on. It is, in a sense, the focal point of global financial decision-making, and it is important to understand the strategies that the Fed implements to prevent severe economic problems and how these strategies work.
The Federal Reserve, headed in Washington DC, is split into 12 regional banks that cover the United States. These regional banks implement monetary policy and participate in collective discussion with the central bank on issues like commercial bank interest rates and reserve ratios for specific circumstances. The Board of Governors, 7 people appointed by the President to oversee the bank in Washington DC, works together to fight problems uniformly across the country, particularly issues with inflation and spending trends.
Managing the Ups and Downs of the US Economy
The Fed has different ways of controlling economic policy, but most frequently it engages in open-market operations, which involves buying or selling government securities (bonds) to either increase or decrease spending. At its core, most factors the Fed tries to control, like inflation and unemployment, depend on spending.
To keep macroeconomic stability, it is customary to try and slow spending during periods of extreme economic growth in order to combat rising inflation. This is done by raising the federal funds rate, or the rate that the Fed loans money out to commercial banks. By doing this, borrowing becomes expensive, less customers take out loans, and spending slows.
The other side of the coin is also true; during recessions, where there is incredibly low spending, the federal funds rate is lowered. This was most recently the case in the 2008 financial crisis, where the Fed dropped the funds rate to 0% to incentivize people to take out loans and spend money. Because of the efforts of the Fed to combat the crisis, a long-term depression was prevented, and the economy slowly returned to normal over the next decade.
Implementing Monetary Policy
Treasury bonds and the fund rate are part of the US government’s larger use of monetary policy, or policy that aims to control the amount of money and spending that is present in the economy at a given time. Easing or stressing monetary policy stimulates other areas of the economy, and it is commonly done by changing the funds rate or by changing government spending.
In some rare cases, like the 2008 financial crisis, the Fed may go to more extreme measures to inject liquidity into the economy. One example is quantitative easing, where the Fed buys back long-term government bonds before maturity at a premium, and in turn increases available capital in the market that is ready to be spent.
The Role and Business of Commercial Banks
The Fed exercises the power to change the reserve ratio requirement for regional and commercial banks. This means that banks have to keep a certain percentage of total deposits as liquidity to assist with loans and other transactions, and it acts as a measure to prevent banking collapse and mass withdrawal.
In turn, the reserve ratio dictates the degree to which commercial banks can make money. When the ratio is low, the bank can loan more capital and earn more total interest on that capital. Lower interest rates usually accompany a low reserve ratio, and more customers will take out loans that have favorable conditions. On the other hand, when the ratio is high, less money is out in circulation and less interest is paid. This often occurs when spending and inflation are too high for healthy market growth, and it acts as a means of slowing activity.
The difference between the federal funds rate and a commercial bank’s loan rate is known as its spread, and this spread indicates the percent of money loaned is made back in interest by the bank. For example, a federal funds rate of 4% is issued on a bank, and the bank borrows a certain amount of money from the Fed. If the bank issues out all the money as loans with 6% interest, the bank nets a profit of 2%, because 4% of the interest they make needs to be paid back to the government for loaning money.
Of course, the system is more complex, with reserves, deposit insurance, and competition manipulating the true profitability of banks. It is undeniable, however, that the hierarchy of banking in the US is what gives its economy the flexibility that allows it to maintain stability even during times of financial panic.
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