Author: John Bouman

The Federal Reserve System The Federal Reserve (the Fed) System in the United States is a system of federal overseeing agencies, committees, and banks. The system was created in 1913, and its original purpose was for the Fed to be the lender of last resort for banks that needed financial assistance. This is still an important function of the Fed. For example, when financial markets crash or or our banks face bankruptcies, the Fed can intervene by making more than the usual amounts of funds available for banks. This allows for more borrowing and provides confidence to investors that the market dip will be short-lasting. The Fed Board and the FOMC The Federal Reserve Board of Governors is in charge of the United States Federal Reserve system. The board consists of seven “governors.” These governors, formerly chaired by  economists Alan Greenspan, Ben Bernanke, and Janet Yellen, and currently lead by Jerome Powell. are appointed by the United States President and approved by the Senate for a period of 14 years. For an up-to-date list of all Federal Reserve Board members, please visit this Federal Reserve website page. As of December, 2025, the seven Federal Reserve Board members were: Top Row f.l.t.r.: Fed Chair Jerome Powell, Vice Chair Phillip Jefferson, Vice Chair for Supervision Michael Barr, Michelle Bowman. Bottom Row: Lisa Cook, Stephen Miran, and Christopher Waller.   Charles Hamlin...

Federal Reserve Tools to Affect the Money Supply The Federal Reserve changes the bank reserves and the money supply of the United States by way of the following three tools. 1. Open Market Operations. Open Market Operations is the most important and most frequently used of the three tools. Open Market Operations is the Fed’s activity of buying and selling U.S. Treasury and federal agency securities. Securities include bonds, notes, and bills. All three are “IOUs,” or proof that someone has lent money. These can be actual certificates or computer entries. The difference between the three securities is the maturity period (the number of years after which the lender agrees to pay back the loan). Bonds mature between 10 and 30 years; notes mature between 1 and 10 years; and bills mature after 1 year or less. Most of the time, the interest rate, which lenders receive, is higher on longer-term securities and bonds. This is because the longer maturity term carries a greater risk and a smaller chance that it will get paid back. The United States Treasury, our federal (central) government’s financial manager, issues the securities to help finance federal deficits. The Federal Reserve Banks then trade these bonds in order to change the economy’s reserves (money supply). To put more money into circulation, the Fed buys securities from the public (see diagram below). Recently, the Fed...

A Bank’s Balance Sheet To understand banks’ reserve requirements and fractional reserve banking, let’s study a bank’s balance sheet. The table below includes entries for a hypothetical bank’s assets and liabilities. Assets are investments and properties that a bank owns. Liabilities are what a bank owes. A typical bank may show the following entries on its balance sheet (the amounts depend, of course, on the size of the bank and its specific transactions). Bank T Assets Liabilities Vault Cash $1 million Equity $2 million Deposits with the Fed $9 million Checkable Deposits $70 million Mortgage Loans $22 million Consumer Loans $18 million Business Loans $20 million U.S. Government Securities $2 million Total Assets $72 million Total Liabilities $72 million For the above bank, total checkable deposits (money in transactions accounts) equals $70 million. If the bank’s required reserves are 10% of all checkable deposits, then this bank must keep at least $7 million in cash or as deposits with the Fed. Its cash plus deposits with the Fed currently equal $10 million, so this bank can still loan out $3 million. This $3 million is called “excess reserves.” Fractional Reserve Banking For our purposes, in order to understand fractional reserve banking, it is sufficient to consider a simplified balance sheet, which includes only total reserves and loans on the asset side, and checkable deposits (funds deposited by the bank’s...

Changes in the Nation’s Money Supply Let’s assume that banks hold on to 20% of all deposits. This means that a customer deposit of $1,000 will allow a bank to loan out $800. This $800 will be spent, then received by person B, and deposited into bank B. Bank B, in turn, can loan out 80%, or $640. Similarly, bank C can loan out 80% of $640, or $512. This process continues indefinitely. Therefore, the initial $1,000 deposit has created demand deposits of an additional $800 plus $640 plus $512, etc. Mathematically, it can be proven that the total increase in the money supply amounts to $5,000 (5 times the initial deposit of $1,000). In general, the following equation illustrates how a nation’s total money supply changes: Change in the nation’s money supply = money multiplier * the initial deposit The Money Multiplier Similar to the multiplier in the Keynesian model, there is a multiplier in the money creation model. The formula for the money multiplier is Money multiplier = 1 / required reserve ratio (one divided by the required reserve ratio)   In the above example: The initial deposit is $1,000. The required reserve ratio is 20%. So the money multiplier is 1 / 20% = 1 / .20 = 5. So the change in the nation’s money supply is 5 times $1,000 = $5,000. The money multiplier...

The Role of the FDIC Most countries’ governments have a deposit insurance agency that insures customers’ bank deposits. In the United States the Federal Deposit Insurance Corporation was created in 1933 during the Great Depression.  The purpose of the FDIC is to insure depositors’ funds. In the event that a bank is unable to satisfy customers’ requests for withdrawals, the FDIC will pay customers up to a certain amount (currently $250,000) per account . Deposit insurance discourages customers from withdrawing all of their money if the customers suspect that the bank is in financial trouble. In the event that there is a so-called “run” on the bank, it will most likely lead to a bank’s bankruptcy, because the bank usually has no more than about 10% of customers’ deposits. The other approximately 90% it has loaned out. It is possible that a bank is very solid, but that customers’ perception is that the bank is in trouble. This perception could turn real if customers’ reactions lead to storming the bank, especially if their money is not insured. The FDIC’s strength is to guarantee people that their money is safe (up to a limit per account), so that a run can be prevented. If the bank is truly in trouble, the Federal Reserve usually intervenes by loaning reserves to the bank or attempting to find a more-solvent partner to merge...