Federal Reserve Functions

Why This Matters

The Federal Reserve isn't just another government agency—it's the institution that controls the money supply, sets interest rates, and ultimately determines whether the economy runs hot or cold. When you study the Fed, you're learning how monetary policy actually works in practice, which connects directly to Unit 4's core concepts: fractional reserve banking, the money multiplier, and how changes in reserves ripple through the entire financial system. Every time the Fed acts, it shifts the money supply, which affects interest rates, which affects investment, which shifts aggregate demand. That chain reaction is what the AP exam tests.

Understanding Fed functions also helps you see the difference between monetary policy (what the Fed does) and fiscal policy (what Congress and the President do). You'll need to explain how the Fed responds to inflation versus recession, why certain tools are more powerful than others, and how Fed actions connect to exchange rates and international capital flows. Don't just memorize that the Fed "conducts monetary policy"—know which specific tools it uses and how each one changes the money supply. That's what earns you points on FRQs.

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Monetary Policy Tools: How the Fed Changes the Money Supply

The Fed's most testable functions involve the three main tools it uses to expand or contract the money supply. Each tool works through a different mechanism, but they all ultimately affect bank reserves and, through the money multiplier, the total money supply.

Open Market Operations

• Buying government securities injects reserves into the banking system—banks gain excess reserves, which they can lend, triggering the deposit creation process
• Selling securities does the opposite, pulling reserves out of banks and contracting the money supply through the multiplier effect
• The Federal Open Market Committee (FOMC) meets eight times per year to set the target federal funds rate, making this the Fed's most frequently used and most flexible policy tool

The Discount Rate

• The discount rate is the interest rate the Fed charges banks for short-term loans through the discount window—raising it discourages borrowing, lowering it encourages borrowing
• Changes signal the Fed's policy stance to markets, though banks typically prefer borrowing from each other at the federal funds rate
• This tool is less precise than open market operations but becomes critical during financial crises when banks need emergency liquidity

Reserve Requirements

• The required reserve ratio determines what fraction of deposits banks must hold—a higher ratio means less excess reserves available for lending
• Lowering the ratio increases the money multiplier (calculated as $\frac{1}{\text{required reserve ratio}}$), amplifying the money supply expansion
• This tool is rarely used because even small changes create large, disruptive swings in bank lending capacity

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Lender of Last Resort: Preventing Financial Collapse

One of the Fed's most important functions is maintaining confidence in the banking system. Because banks operate under fractional reserve banking, they don't keep enough cash on hand to pay all depositors at once—which makes them vulnerable to panics.

Emergency Lending Function

• The Fed provides emergency loans to solvent banks facing temporary liquidity shortages—this prevents bank runs from spreading through the financial system
• Loans come through the discount window, where banks can borrow reserves using collateral when they can't obtain funds elsewhere
• This function exists because a single bank failure can trigger contagious panic, threatening the entire deposit creation process

Financial System Stability

• The Fed monitors systemic risks—interconnected failures that could cascade through the banking system and freeze credit markets
• Coordinates with other regulators to identify vulnerabilities before they become crises, not just after
• During the 2008 financial crisis, the Fed created emergency lending programs that went far beyond traditional discount window operations

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Banking Regulation: Keeping the System Sound

The Fed doesn't just influence banks through monetary policy—it directly supervises them to ensure the fractional reserve system doesn't collapse under excessive risk-taking.

Bank Supervision and Examination

• The Fed conducts regular examinations of banks to assess their capital adequacy, asset quality, and risk management practices
• Ensures banks maintain sufficient reserves and don't take on risks that could threaten depositors' funds
• Protects the deposit creation process by preventing the kind of reckless lending that leads to bank failures and credit contractions

Setting Reserve Requirements

• Determines the minimum reserves banks must hold against checkable deposits—this is both a regulatory function and a monetary policy tool
• Required reserves appear on bank balance sheets as assets that cannot be lent out, while excess reserves can fuel the money multiplier
• The current required reserve ratio directly determines the maximum money multiplier: if the ratio is 10%, the multiplier is $\frac{1}{0.10} = 10$

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Currency and Payments: The Fed's Operational Functions

These functions are less frequently tested but help you understand how the Fed supports the basic infrastructure of the monetary system.

Issuing Currency

• The Fed controls the supply of physical currency (paper money) in circulation, which is one component of the monetary base ($MB = \text{currency} + \text{bank reserves}$)
• Currency in circulation is part of M1, the narrowest measure of the money supply
• While less important than electronic money creation, physical currency still matters for the currency drain that reduces the actual money multiplier below its theoretical maximum

Operating the Payments System

• Facilitates electronic transfers between banks, ensuring that checks clear and wire transfers complete efficiently
• The Fed processes trillions of dollars in transactions daily, making it the backbone of the national payments infrastructure
• Payment system efficiency affects the velocity of money—how quickly money circulates through the economy

Fiscal Agent for the Government

• Manages the U.S. Treasury's accounts and processes government payments, from Social Security checks to tax refunds
• Issues and redeems Treasury securities (bonds and bills), which are the assets the Fed buys and sells in open market operations
• When the government runs a budget deficit, the Treasury issues bonds that the Fed may later purchase, connecting fiscal and monetary policy

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Quick Reference Table

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Self-Check Questions

1. If the Fed wants to decrease the money supply, which two tools could it use, and how does each one work through bank reserves?

2. Compare open market operations and reserve requirement changes: Why does the Fed prefer one over the other for routine monetary policy?

3. A bank has $$100 million in deposits and the required reserve ratio is 10%. Calculate its required reserves, and explain what happens to the money supply if the Fed lowers the ratio to 5%.

4. How does the Fed's role as lender of last resort connect to the vulnerability created by fractional reserve banking? What problem is it designed to prevent?

5. An FRQ asks you to explain how the Fed can respond to rising inflation. Identify the appropriate policy stance (expansionary or contractionary), name two specific tools the Fed could use, and trace how one of them affects aggregate demand.