THE CIRCULAR FLOW OF THE NATIONAL ECONOMY

THE CIRCULAR FLOW OF THE NATIONAL ECONOMY

Federal Reserve Bank System

The Federal Reserve Bank System (the Fed or FRB) is the nation’s central bank. The U. S. Congress
established the Fed, December 23, 1913, as a Christmas present to then President Woodrow Wilson who had
sought the establishment of a central bank authority. The chief responsibility of the Fed is to regulate the flow
of money and credit to promote economic growth and stability. The goal is a monetary policy which encourages
high employment, stable price levels, and a satisfactory international balance of payments. The Fed’s monetary
policy attempts to counteract inflation, recession, deflation or any other undesirable shift in the national
economy.

The Fed’s Board of Governors formulates monetary policy and shares responsibility for its application with the
12 District Federal Reserve Banks throughout the nation. The President of the United States appoints the
governors of the FRB for 14-year terms, subject to confirmation by the U. S. Senate. These long terms are
intended to insulate the governors from outside pressures. The Chairman and Vice Chairman of the Fed are
appointed by the President and confirmed by the Senate for four-year terms. These appointments are often
renewed by Presidents of various administrations.

Monitoring the Money Supply

In an effort to avoid the peaks and valleys and “boom or bust” business cycles that spawn liquidity and credit
crises, the Fed monitors economic conditions and controls the supply of money and credit. This is a delicate
balancing act.

If the Fed makes too little credit available, borrowers may bid against each other for capital/funds that drive up
the cost of borrowing. People then buy and borrow less, investments and sales decline, and a recession may
follow. On the other hand, too much available credit translates into over stimulation of the national economy
and invites inflation, including bubbles in the housing market. When these bubbles burst, deflation often
follows.

To accomplish its goals, the Fed currently uses four basic tools:

■ Reserve Requirements

Member banks must set aside and keep as reserves a certain percentage of customer deposits and of
the mortgage and other loans held in portfolio or for which servicing and contingent liability is
retained. By raising or lowering these capital reserve requirements (based upon risk weight), the Fed
increases or decreases the amount of money in circulation. An increase in reserve requirements means
banks have less money to lend, mortgage and other loan interest rates will likely increase, and
borrowing and spending will slow. Conversely, a lessening of the reserve requirements increases
capital/funds to lend and should lead to lower interest rates; borrowing and spending can then be
expected to increase.

■ Discount and Federal Funds Rates

The discount rate is the interest rate the Fed charges on money it lends to member banks. The interest
rates for federal funds established by the Fed is the rate charged by member banks to each other for
overnight or short term liquidity or is the amount a member bank would demand to invest capital/funds
with another member bank. These rates are regulated by and subject to changes directed by the Fed. A
decrease in the discount rate may encourage bank borrowing, increasing deposits which the bank may
loan to businesses and consumers. An increase in the discount rate will have the opposite effect.
Increasing the rate for federal funds correspondingly increases the cost of money to member banks,
thus reducing the available liquidity for lending. This also would increase the cost of borrowing.

■ Open Market Operations

The Fed also uses open market operations (buying and selling of government securities) to influence
the amount of available credit. When the Fed buys government securities, cash is deposited into
sellers’ bank accounts, increasing reserves and allowing banks to extend more credit to borrowers. If
the Fed sells securities, the opposite effect occurs.

■ Acquiring Non-Performing Assets

As part of the mortgage melt down, many depository institutions and non-banks (lenders other than
historic depository institutions) were holding on their books or in related entities, a significant amount
of non-performing assets primarily in the form of mortgage backed securities. These non-performing
mortgage backed securities impair the liquidity of depository institutions and non-banks that are
required to increase capital reserves in relationship to these non-performing assets. The result of
increased capital reserves is the reduction of lending activities. The Fed has been purchasing some of
these non-performing mortgage backed securities to reduce the applicable reserve requirements,
thereby increasing capital ratios of the depository institutions and the non-banks that were holding
these non-performing assets. The purpose of the foregoing Fed acquisitions is to enhance the ability of
depository institutions and non-banks to make new loans.

Supervision of Depository Institutions

The Office of Thrift Supervision (OTS) was created pursuant to the restructuring required by FIRREA. The
OTS is an office within the Fed that regulates federally licensed and chartered savings and loans and savings
banks.

FIRREA also reorganized the Federal Deposit Insurance Corporation (FDIC) into four offices with two sub-
agencies. The original four offices consisted of the Deposit Insurance Fund (DIF), the OTS, the Resolution
Trust Corporation (RTC), and the Resolution Funding Corporation (RFC). The RTC is no longer operative.
DIF currently exists as the insurance fund under FDIC. DIF has subsumed the two insurance funds formerly
known as the Bank Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF).