How Does the Federal Reserve Work?

Do you know what the central bank of India is called? The Reserve Bank of India. What do you call the central bank of Australia? The Reserve Bank of Australia. How about the central bank of America? If you stated the "Reserve Bank of America" or the "Bank of America," think again. It is called the "Federal Reserve." It is also referred to as the "Fed."

The Fed is responsible for making and printing money. It has also evolved over time with each financial crisis. The Fed was created on December 23rd, 1913. It was signed into law by President Woodrow Wilson. During the panic of 1907, many businesses went bankrupt. As a result, people started pulling their deposits out of banks, a phenomenon known as "bank runs." Due to an excessive number of bank runs, many banks started suffering financially and went out of business. These banks had no support system to help them during times of financial crisis. Eventually, America decided that there needs to be a central bank that other banks across the country can rely upon during times of financial hardships.

There are twelve Federal Reserve banks across the country. Initially, there was only a president, but during the Great Depression (which was caused by the circulation of lots of money and tight lending policies), the Fed decided to implement the system of having a Board of Governors, which consisted of seven governors. They also had a FOMC (Federal Open Market Committee) which consists of five presidents, four of which rotate. The system was built to battle the financial crisis. 

During the 1970s, the Fed attempted to keep prices stable and have a high employment rate at the same time. In the early 1970s, Arthur Burns was the chairman of the Fed. He and President Nixon were good friends, and as per Nixon's wish, Burns lowered interest rates significantly. Sadly, seldom (if ever) do both low inflation and high employment work out together. Due to this, the United States experienced the "Great Inflation," when the inflation rate reached close to fifteen percent by 1980. 

Paul Volcker, who served as the chairman of the Fed from 1979 to 1987, took the opposite approach. He raised interest rates to nearly twenty percent, which caused the unemployment rate to shoot up to ten percent. Volcker was disliked by many people due to this, and the Fed earned a bad reputation. Due to Volcker's actions, the United States economy improved between the 1980s and 1990s, with a high unemployment rate being the cost. While Volcker did improve the economy during his time as the chairman of the Fed, many economists today believe that raising the interest rates too high is bad in the long run.

In 2008, the chairman of the Fed, Ben Bernanke, lowered interest rates to zero percent, in order to help revive the American economy during the financial crisis. Jerome Powell, who has been the chairman of the Fed since 2018, did the same in 2020, to help the economy during Covid-19. Lower interest rates make it easier for borrowers to take loans, spend, and in turn, help the economy grow. During the July 25th to 26th meeting (2023), the Fed raised interest rates by a quarter of a percentage point. Despite inflation being under control, the Fed believes that economic activity in the United States is too high, which warrants an increase in interest rates.

It is interesting to see how the Fed has evolved over time, what decisions it has made, and contemplate what it will do in the future. Only time will tell.