Federal Reserve System – Definition

Cite this article as:"Federal Reserve System – Definition," in The Business Professor, updated June 2, 2019, last accessed July 6, 2020, https://thebusinessprofessor.com/lesson/federal-reserve-system-definition/.

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The Federal Reserve System (The Fed) Definition

The Federal Reserve System (FRS), variously referred to as the Federal Reserve or the Fed, is the central banking authority in the United States of America that is responsible for regulating the monetary and financial system in the country. The  Fed was formed by the passing of the Reserve Act on Dec. 23, 1913 by President Woodrow Wilson, and comprises a federal agency in Washington, D.C., the Board of Governors, and 12 regional Federal Reserve Banks in major cities across the USA.

A Little More About the Federal Reserve System

The Federal Reserve System came into being as a result of an initiative by the U.S. Congress to present to the nation a secure, flexible, and stable monetary and financial system. The Federal Reserve System’s current responsibilities can be broadly classified into four categories: 1) Administering the monetary policy of the United States by shaping money and credit conditions in the economy in the quest for full employment and stable prices. 2) Managing and regulating banks and various other major financial institutions in order to guarantee the safety and wellbeing of the American banking and financial system, while safeguarding the credit rights of customers. 3) Preserving the stability of the financial system and restraining systemic risk that is common in financial markets. 4) Offering specific financial services to the government of the United States, in addition to several U.S. financial institutions, and foreign official institutions. The Fed also plays a significant role in running and supervising the payments systems of the United States.

Components of the Federal Reserve System

  1. The Board of Governors: The Board of Governors, also known as the Federal Reserve Board, is stationed in in Washington, D.C and is the core leadership body of the Federal Reserve System. It is the national component of the Federal Reserve System and consists of seven governors appointed by the President of the United States and confirmed by the Senate. Whereas both the Chairman as well as the Vice-chairman are appointed to four-year terms, the governors enjoy 14-year staggered terms.
  2. Federal Reserve Banks: The Federal Reserve System comprises a total of 12 Federal Reserve Banks as well as 24 branches. These banks as well as their branches operate under the purview of the Board of Governors. The Federal Reserve Banks are located at the following cities:
  • Boston
  • New York
  • Philadelphia
  • Cleveland
  • Richmond
  • Atlanta
  • Chicago
  • St. Louis
  • Minneapolis
  • Kansas City
  • Dallas
  • San Francisco
  1. Member Banks: The Federal Reserve System boasts membership of almost 40% of the 8000+ commercial banks registered in the United States. While it is mandatory for national banks to be members of the FRS, state-chartered banks may seek membership as long as they satisfy specific requirements.
  2. Federal Open Market Committee (FOMC): The FOMC is the body responsible for formulating the monetary policies of the Federal Reserve System. The key consideration during policy formulation is to promote stable prices as well as economic growth.
  3. Advisory Councils: There are three statutory advisory councils that advise the Board on matters of current interest. These are:
  1. The Federal Advisory Council
  2. The Consumer Advisory Council
  3. The Thrift Institutions Advisory Council

These three councils boast members drawn from each of the 12 Federal Reserve Districts.

References for the Federal Reserve System

Academic Research on Federal Reserve System

The Federal Reserve System, Warburg, P. M. (1930). Its Origin and Growth, 2. This book aims to highlight the fact that the Federal Reserve System is the result of the efforts of several intellectuals and as such, it is a common property of all. Therefore, the welfare of the Federal Reserve System should be treated as a common concern and responsibility by all. The author even goes on to state that the reserve system needs to be treated as a national monument and treasured a symbol of national achievement.

Inflationary bias of the Federal Reserve System: a bureaucratic perspective, Toma, M. (1982). Journal of Monetary Economics, 10(2), 163-190. Since the Federal Reserve System is not financed by the Congress, it utilizes interest payments on its government security portfolio to fund its operations. Such a unique financing arrangement underlines a bureaucratic model of Federal Reserve official behavior. The empirical segment evaluates the bureaucratic model by scrutinizing the Federal Reserve System’s record of expenditures since 1947 as well as its policy actions during periods of constitutional reassessment.

Policy objectives of the Federal Reserve system, Potts, G. T., & Luckett, D. G. (1978). The Quarterly Journal of Economics, 525-534. This paper identifies three primary motivations behind the several empirical studies that have sought to quantify the reaction function of the Federal Reserve. These are: 1) Sheer professional curiosity has led scholars to try to determine (a)  if the Federal Reserve is responsive to the goals defined by the Employment Act of 1946, and (b) the Fed’s ranking of policy objectives. 2) The question pertaining to the endogeneity of the Fed’s behavior. 3) The question pertaining to the independence of the Federal Reserve System.

Preliminary evidence on the use of inputs by the Federal Reserve System, Shughart, W. F., & Tollison, R. D. (1986). In Central bankers, bureaucratic incentives, and monetary policy(pp. 67-90). Springer, Dordrecht. There are three primary objectives of the Federal Reserve System. They are: 1) Ensuring full employment. 2) Encouraging economic growth. 3) Maintaining stable prices. While historically, studies have been concentrating on the Federal Reserve’s performance that revolved around the behavior over time of macroeconomic variables such as the aggregate price level, interest rates, and national income, newer studies have turned their attention to the bureaucratic incentives faced by central bank officials in order to provide an explanation for the monetary policy record of the Federal Reserve System.

Federal Reserve System Implementation of Monetary Policy: Analytical Foundations of the New Approach, Axilrod, S. H., & Lindsey, D. E. (1981). The American Economic Review, 71(2), 246-252. This paper starts with a summary of the analytical framework that is fundamental to making the choice between a reserve aggregate and a federal funds rate operating target, besides some previous research pertinent to this issue. The authors then explain the technical aspects of implementing the new procedures. They also contrast these procedures to the theoretical foundation of previous empirical outcomes. Lastly, the authors review the experience with the new procedures and draw certain conclusions.

Designing a Central Bank for Europe: a cautionary tale from the early years of the Federal Reserve System, Eichengreen, B. (1991). National Bureau of Economic Research. This paper scrutinizes the various structural and operational challenges associated with designing a Central Bank for Europe. The author contends that the founding and early operations of such an institution would invariably draw parallels with the American Federal Reserve System. There are several unresolved issues pertaining to the structure and operation of the European Central Bank (ECB), such as: 1) The level of independence that national banks in Europe can retain after the transition to a common currency. 2) The various voting and mediation rules that need to be incorporated into the ECB so as to facilitate the resolution of conflicts among national representatives within the central bank’s governing council. 3) The possible roles that existing central banks should play in the implementation of pan-European policies after the founding of the ECB.

Origins of the Federal Reserve System: International incentives and the domestic free-rider problem, Broz, J. L. (1999). International Organization, 53(1), 39-70. This paper seeks to explain the way in which the American society dealt with the issues stemming from collective action that often restrict the production of public goods to insufficient level. Basically, the paper illustrates the political process of creating an infrastructural cornerstone of the modern American economy notwithstanding incentives that would have motivated people to finance the improvement. The author introduces a joint products (selective incentives) model in order to demonstrate the workings of the voluntary collective action of the Federal Reserve Act.

The collateral frameworks of the Eurosystem, the Federal Reserve System and the Bank of England and the financial market turmoil, Cheun, S., von Köppen-Mertes, I., & Weller, B. (2009). ECB Occasional Paper. This paper describes the various attributes of the operational as well as collateral frameworks of three central banks that were severely affected by the global financial turmoil that began in the second half of 2007 – the Federal Reserve System, the Bank of England and the Eurosystem. The authors appraise the various circumstances that shaped these discrete frameworks before the onset of the 2007 crisis, and then proceed to evaluate the reactionary measures adopted by the three major institutions in response to the crisis. Finally, he paper provides an analysis of the extent to which these measures depended on the initial design of the operational and collateral framework.

Payment system disruptions and the federal reserve following September 11, 2001, Lacker, J. M. (2004). Journal of Monetary Economics, 51(5), 935-965. This paper reviews the impact of the September 11, 2001 terror attacks on monetary and payment systems as well as the Federal Reserve’s response to the crisis. The Federal Reserve sought to counterbalance the increase in demand triggered by interbank payment disruptions in the aftermath of the terror attacks by increasing the supply of banks’ balances. The author also mentions the positive effect that relatively benevolent banking conditions had on the credit policy of the Federal Reserve.

Competition, efficiency, and cost allocation in government agencies: Evidence on the Federal Reserve System, Cavalluzzo, K. S., Ittner, C. D., & Larcker, D. F. (1998). Journal of Accounting Research, 36(1), 1-32. This paper scrutinizes the impact that the introduction of external competition as well as free-for-service requirements had on the managers of the Federal Reserve System. The authors specifically look for any possible efficiency improvements or changes in cost allocation procedures so as to move costs to services that are less competitive. Expert opinion is mostly divided in this regard. Some analysts do acknowledge a positive effect of external competition and free-for-service requirements in the form of a reduction of costs, better response to the needs of the markets, promotion of innovation and a reduction of the overconsumption of government services deemed to be free. The author concludes that it is possible for competition to provide an important tool in the nation’s present efforts to reinvent government. However, its is also necessary to consider the competition’s influence on managerial incentives and the various  utilities as well as validity of the data reported by the cost accounting system.

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