What is the Federal Reserve Act?

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Definition:

The Federal Reserve Act is a 1913 law that created the Federal Reserve System in the United States, introducing a central bank to oversee monetary policy and aiming to stabilize the economy.

🤔 Understanding the Federal Reserve Act

The Federal Reserve Act is a law that was passed in 1913. The act created the Federal Reserve System, establishing a central bank in the United States and tasking it with creating a more stable financial system. The Federal Reserve System still exists today, making the Federal Reserve Act one of the cornerstones of the modern American financial system. The Federal Reserve (known as “The Fed”) manages the money supply of the United States, helping it influence inflation (the phenomenon of money losing value over time). It also serves as a lender of last resort for banks, providing emergency loans if cash balances get too low, helping it influence interest rates.

Example

One example of the Federal Reserve’s efforts to stabilize the economy is its reaction to the 2008 financial crisis. In response to the crisis, the Federal Reserve used strategies such as reducing interest rates and buying mortgage-backed securities (bonds secured by real estate loans) from banks. These increased the money supply in the economy and encouraged consumers to spend rather than save, helping the country out of recession.

Takeaway

The Federal Reserve is like a general in the army…

When fighting a war, generals gather information about the enemy and use that information to determine strategies and tactics. Like a general, the Federal Reserve gathers data about the economy and uses that information to take action that encourages a stable, functional, economic system for the country. When the economy is slow, the Fed tries to encourage spending. When inflation is too high, it works to reduce it.

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What is the Federal Reserve Act?

The Federal Reserve Act is a 1913 law passed by the United States Congress and signed by President Woodrow Wilson.

The act established the Federal Reserve system in the United States, creating a central bank and regional banks that would serve as the backbone for the system. The act gave the Federal Reserve relative autonomy from Congress and other branches of government.

The act tasked the central bank with managing the nation’s monetary policy (management of things like money supply and interest rates) to encourage stable growth. For example, the Federal Reserve puts more money into circulation to make sure there is enough paper money for people to use to conduct business.

The Federal Reserve Open Market Committee, established in 1935, includes seven members of the board of governors appointed by the President of the United States, the president of the Federal Reserve Bank in New York, and the presidents of four other regional Federal Reserve Banks.

The Federal Reserve, while serving as a central bank, includes a dozen regional federal reserve banks. These banks work together to accomplish the overarching goals of the Federal Reserve and to provide input from each region of the United States.

The committee discusses the economic situation and takes action as necessary. For example, the Federal Reserve Open Market Committee can decide to buy or sell government bonds to increase or decrease the supply of money in the economy. Changing the money supply can help encourage or discourage inflation. It also sets the federal funds rate, a benchmark interest rate that impacts the rates for all sorts of things, like savings accounts and credit cards.

Why was the Federal Reserve Act created?

The Federal Reserve Act was created in response to a series of economic panics in the United States. Because the country lacked a central bank that could manage its economic and financial systems, the government regularly turned to wealthy individuals to help stabilize the economy in uncertain times.

By the early 1900s, the United States was the only western power with no central bank, and it experienced regular financial panics. For example, in 1895, the boom in the railroad industry led to some banks failing as they tried to enter the market. This caused consumers to panic and run on other banks, leading to a cascade of failures. The government created the Federal Reserve Act to encourage stable growth in the economy and to cut down on the number of financial panics.

What were the objectives of the Federal Reserve Act?

The Federal Reserve Act created the Federal Reserve and gave it several objectives related to managing the nation’s financial system.

Though the goals have evolved over time, the core tenets have remained. First, the Federal Reserve is tasked with maintaining full employment. Second, the Fed is tasked with ensuring stable prices for goods and services, meaning that it should fight against high levels of inflation or deflation.

The act also gave the Fed tools that it could use to accomplish these goals, such as open market activities and the power to set the federal funds rate, a benchmark interest rate that influences most other interest rates in the nation.

In 2012, the Fed offered clarification of its long-term goals, specifying that it targets an inflation rate of 2% per year on average. Communicating this target has helped the Fed keep people’s expectations set and made it easier to reach this target.

The Federal Reserve also announced in 2019 that it expects the target level of unemployment to sit between 3.5% and 4.5%. This level of unemployment accounts for frictional unemployment (unavoidable, healthy, unemployment) in the economy.

What events led to the creation of the Federal Reserve Act?

An economic panic in 1895, followed by another panic in 1907, were the impetus for creating for the act. The panics were caused by bank failures, which resulted in people trying to withdraw all of their money at other banks, creating a cascade of bank failures. The United States was one of the only major world powers without a central bank. When the panic of 1895 began, the U.S. government had to turn to wealthy individuals, like J.P. Morgan, to help provide cash to banks and stabilize the economy.

When the 1907 panic began, Congress issued emergency currency to banks and established the National Monetary Commission. The commission, headed by Senator Nelson Aldrich, spent three years speaking to government officials and bankers in Europe and submitted a plan for a National Reserve Association to Congress in 1912.

Congress struck down Aldrich’s plan because it provided too much power to the banks. For example, it established a board of 46 members, 40 appointed by major banks and six by the government.

Major opposition to the plan came from the Democratic Party, and the election of Woodrow Wilson (who strongly opposed the idea) put the final nail in the plan’s coffin.

During Wilson’s presidency, Representative Carter Glass headed a committee to reform the plan. Glass’s system created multiple regional reserve banks rather than a single one. With input from President Wilson, Glass, who favored autonomous regional banks, added a plan for some government oversight of the Federal Reserve Banks in the form of a Federal Reserve Board.

Glass submitted his plan for debate to Congress. Senator Robert L. Owen offered amendments, limiting the number of regional banks to no more than 12 and adding provisions to assist smaller banks instead of favoring large ones. Owen’s plan ultimately passed Congress and was signed into law.

Who signed and supported the Federal Reserve Act?

Woodrow Wilson signed the Federal Reserve Act in December 1913, creating the Federal Reserve System.

President Wilson spent much of his campaign calling for banking and currency reform. After his election, the Democratic Party created the House Banking Committee, which devised the first version of the Federal Reserve Act. The House passed the act and sent it to the Senate.

In the Senate, Democrats generally supported the act. At the time, the party had a rule that called for all Democrats in the Senate to support a bill without amendments if two thirds of the party supported it. Thus, the act passed the Senate with minor changes in a nearly party line vote with Democrats in favor and Republicans against.

Who opposed the Federal Reserve Act?

The Federal Reserve Act passed along a largely party-line vote, with Democrats favoring the act and Republicans opposing it.

Small banks were one major source of opposition for early versions of the act. It created several major reserve banks across the country. Smaller banks feared that these banks would wield too much power under the plan, eventually driving them out of business. It was eventually restructured to provide more power to small banks and protect them from larger ones.

After these amendments, and other changes that provided for more government oversight of the Fed, large banks began to oppose the act. Conservatives also tended to oppose the act because it was a significant change from the country’s previously hands-off economic policies.

Opposition to central banking has a long history in the United States. Alexander Hamilton was one of the first advocates for a central bank shortly after the nation formed. Many of his political opponents disliked the idea. Even after Hamilton managed to create the first national bank, it was eventually closed when President James Madison refused to renew its charter.

To this day, many Americans distrust or dislike the Federal Reserve. In 2019, only half of Americans felt that the Fed was doing a good job at managing the country’s financial system. Politicians on both sides criticize the Fed for its actions, claiming it does not do enough to stabilize the economy or acts in ways that inhibit the growth of the economy.

What were the effects of the Federal Reserve Act?

The Federal Reserve Act helped provide liquidity to banks in the United States. Prior to the Federal Reserve Act, banking regulations varied widely across the country and typically required that banks maintain a significant portion of their assets in reserve. This made running a bank profitably difficult. It also put banks in a precarious position because it was difficult for them to secure funds if they needed to borrow large amounts quickly.

The Federal Reserve Act helped deal with this issue. The Federal Reserve Banks have the power to lend money to banks as a last resort, providing cash flow and helping them avoid closing due to bank runs.

The Federal Reserve Act played an important role in World War I as the banks it established became operational. The banks helped the government borrow money by issuing Liberty Bonds. These bonds gave the government the funds it needed to pay for the war.

When the war ended, the amount of available credit decreased and the country entered a short recession. The Fed’s actions, adjusting interest rates and increasing the money supply, helped the country recover quickly.

The role of the Fed evolved after the war, especially with the Banking Act of 1935, which created the Fed Open Market Committee. This committee had the power to buy and sell government bonds on the open market, giving the Fed even more control over the supply of money in the American economy.

Ultimately, the effect of the Federal Reserve Act was to increase the power of the government in managing the economy. It also helped promote stability over frequent cycles of booms and busts, punctuated by frequent financial and banking panics.

How does the Federal Reserve Act affect us today?

The Federal Reserve Act established the Federal Reserve system, which continues to operate to this day.

One example of how the Fed affects people today is the federal funds rate. The federal funds rate is the interest rate that banks use when lending money to each other overnight. It serves as a benchmark interest rate for the economy.

The higher the federal funds rate is, the higher other rates (like mortgage rates, auto loan rates, and the rates paid on savings accounts or bonds) tend to be. The Fed can adjust the federal funds rate to encourage people to spend more or to save more.

The Fed also acts to help the country avoid recession or to reduce its effects. For example, in 2008, the Fed cut interest rates to encourage more consumer spending to help bolster the economy.

It also began a policy called quantitative easing, which involved large-scale purchases of securities on the open market. To fund these purchases, the Fed effectively created new money, increasing the money supply in the economy.

The Fed also sets a target for inflation. A low level of inflation can benefit an economy by encouraging spending. At the same time, high levels of inflation tend to be bad for the economy because they make it harder for banks to lend money. The Fed uses its tools, including open market operations and the federal funds rate, to point the economy toward the desired inflation rate.

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