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What is the Federal Reserve? Answers to Economics Questions You've Been Dying to Ask

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What is the Federal Reserve? Answers to Economics Questions You've Been Dying to Ask
Image Credit: AP

Updated: Jan. 31, 2014

On Saturday, Ben Bernanke will step down as the chairman of the Federal Reserve after eight turbulent years in the role. Janet Yellen, taking his place as the country's central banker, will be officially sworn in next week. The Brooklyn native, 67, will be the first ever woman to hold the position since its inception 100 years ago.  

But let's step back. Why do we have a Federal Reserve in the first place, what is its function, and how did it come to exist?

When Alexander Hamilton became secretary of treasury in 1789, there was no real currency. There were local bank currencies, but no national centralized system in place for coining and circulating money. States often had to barter in order to trade.

After the revolution, states were in debt, and the big question was: Should the federal government assume all outstanding state debt? Hamilton proposed the creation of a central bank, which would assume the debt of the nation — a controversial move because some states had more debt than others. As a compromise with the South, which was not heavily in debt, the politicians conceded to move the nation’s capital from Philadelphia to Washington, D.C.  

Here's a short version of the story: There were a few attempts and fails at establishing a central bank of the United States. Hamilton oversaw the creation of the First Bank of the United States national bank, which received a 20-year charter. However, the charter was not renewed by Congress in 1811, losing by one vote. 

In 1817, Congress Commissioned the Second Bank of the United States, which also received a 20-year charter. Once again, anti-bank sentiment — embodied by President Andrew Jackson — meant the expiration of the national bank's charter without renewal.

The U.S. went without a central bank until 1913, when Congress passed, and President Woodrow Wilson signed, the Federal Reserve Act, which put into place the central banking system we have today. 

1. What is the Federal Reserve?

It is the Central Bank of the U.S. It is independent and insulated from the government; they do not receive money from Congress. They are the banker of the government. 

2. Who are they?

The board is made up of seven governors (the chairman is one of them.) The chairman serves four-year terms, appointed by the president and confirmed by Senate. The other governors serve 14-year terms that are non-renewable.

The Federal Reserve System is the overarching body. Within it, there are 12 Federal Reserve Banks all around the country, each one located to serve 12 geographical regions of the country. The Federal Open Market Committee is the monetary policy-making body of the system. It is comprised of the seven Governors, plus the chairman of the New York Fed, plus four rotating members from the other districts.

3. How is the Fed different from the Treasury?

The Fed sets monetary policy; the Treasury sets fiscal policy. Simply put, monetary handles the supply of money and fiscal handles how that money is spent

4. What is the Fed’s governmental mandate?

The Federal Reserve has a dual mandate: to keep prices stable (avoid inflation and deflation; keep inflation at about 2% — which means prices go up 2% per year on average), and to ensure full employment. 

5. Those are the ends. But what are the means?

Most importantly, the Fed sets low short-term interest rates (The Feds Funds Rate) for whatever the Treasury Department is borrowing at. ("Short-term" can mean anywhere from overnight to a couple of months.) Interest rates move in the opposite direction from loans.

The Fed does not determine or have any control over the long-term interest rates. This is an important distinction. They can influence them, and hope to do so, but they cannot set them.   

6. What challenges are they facing right now?

They need to walk a fine line: stimulate growth in a slow economy without triggering inflation. Goals: unemployment below 6.5%, and inflation at or closely around 2%.

As of December, unemployment was at 6.7%. The more telling number is underemployment, which is at 13.1%. That figure includes people who are unemployed, want to work but have stopped looking, and people who are employed part-time but want and need to be employed full-time. 

7. Some fun facts about the past chairmen

There have been 14 in total, starting under President Woodrow Wilson. They have all been middle-aged white men.

The 'S.' in "Ben S. Bernanke" stands for "Shalom." Bernanke grew up in the small town of Dillon, South Carolina, and worked construction jobs and waited tables at a Mexican restaurant before heading to Harvard.

Alan Greenspan was Bernanke’s predecessor. Greenspan served under Reagan, H.W. Bush, Clinton, and Bush.

Before Greenspan came Paul Volcker — yes, as in the Volcker Rule of Dodd-Frank.

The longest-serving chairman was William McChesney Martin, Jr., who served for nearly 20 years through five presidents — Truman, Eisenhower, Kennedy, Johnson, and Nixon.

8. Trivia: Test yourself on the Fed!

1. True or false: The Fed deals with fiscal policy.

2. True or False: The Fed is a body within the government.

3. True or false: Quantitative easing is a tool that is commonly used.

4.  True or false: There are term limits for the chairman.

5. In what year was the Fed created?

6. And under which president?

7. True or false: Inflation should be at around 3%.

8. True or false: Alan Greenspan was the longest-serving chairman.

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