The Federal Reserve

Money, money, money! We use it, we save it, and we need it in our daily lives.

But where, you might ask, does our money come from? This is where the Federal Reserve comes in.

Money in the bank

To begin with, let’s talk about banks.

We all get banks, right? You deposit money in and others take out loans.

But what goes on in-between?

First of all, banks are a business. While banks call it a deposit, in reality, you are loaning the bank money for the sole purpose of the bank making money. Per regulations, banks must keep a certain amount in reserve so that depositors can withdraw out whatever amount of money they wish. The rest of the money in the bank gets loaned out, to be repaid plus an extra fee called the interest.

If you think about it, banks are kind of weird. You put your money in and expect to be able to withdraw it on demand.

But at no time do banks ever have all the deposited money. All they usually keep, hopefully, is enough money to handle withdrawals. The entire banking system is based on the hope that there won’t be too many withdrawals.

Depositors panicking and demanding their money, in mass, is what is known as a “bank run,” or “run on the bank,” and can destroy a bank and wipe out the savings of those with deposits in it.

All in-house

Throughout history, there were periods when widespread panic about the banking system caused a large number of bank runs and bank failures. The highly technical term for such a period is a "bank panic." An important one for our story occurred in 1907 and caused some to ask if there was some way to prevent such panics from happening again.

And so it came to pass that in 1910 Senator Aldrich and a group of leading bankers secretly met to draft a law to create a new central bank for the United States. Now the United States had two banks previously. Neither none ended well, but these men decided to try again.

So in 1913 while most of Congress was away during their Christmas break, the Federal Reserve Act was passed and signed by Woodrow Wilson.

It has been said that the Federal Reserve is poorly named, being neither Federal nor a reserve. In truth, it is a private corporation. While the chairman is a lifetime appointment by the President, the shareholders are all from among the big banking houses in the United States.

The Federal Reserve, also known as the Fed, or the central bank of the United States is, in fact, a banker's bank. Its job is to make money – literally.

Imagine two scenarios:

In either case, all you need to do is is give the Fed a bond or IOU promising to pay back the amount requested plus interest. Then the Fed has the treasury department print up the money to be loaned out.

Easy money, just like that!

The Federal Reserve uses this power to affect how much money is floating around. There are many ways they can do this, but a chief way is by changing what is called the “prime rate,” or interest rate charged when they loan out money.

An example:

Suppose the prime rate is 5%, this means that for every $100 loaned you will be charged $5 as interest. Now, suppose you are a bank. It might, given this example, be foolish for you to charge a smaller interest rate on your loans; say, only 3%. Why? Because if you had to borrow from the Fed you would end up paying more than you would get from loaning the money out. You then need to charge at least the prime rate on your loans.

The prime rate then ripples out to the interest rates charged by banks across the nation. As the prime rate goes down, bank interest rates go down. This means easy credit, lots of borrowing, and more money for all. The reverse is also true if the Feds raise their rate.

The down-side

All this sounds mighty dreamy. We have an institution to regulate the amount of money out there, ensuring a beautiful economy and stable prices. But this monetary “Dudley-do-Right” has its critics.

For example, consider what money really is. In the creation of this nation, money was backed by a certain amount of precious metals or sometimes by land.

Money was the extension of physically valuable objects. You could hold it, own it. Now, money is created because some institution somewhere took out a loan. This means that we don't fully own our money any more than one can fully own a car that is financed or a house that is mortgaged.

But beyond this, now the money is based on debt. No debt and borrowing, no money. Living purely within our means would mean the banks have less call to borrow from the Fed and more incentive to pay off their IOUs. But to do so means there is less money in circulation and a return to the conditions of the 1930s.

As a nation, we cannot return to a life of frugality and living within our means.

On the web

Banking explained

This briefly and simply explains how banks work.

How Banks Create Money

Strange as it may seem, banks create money (in a way). This video explains how.

What Is The Federal Reserve?

How does the Federal reserve work to control the amount of money that is circulated? This video explains how.

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