Mercado Inst. Financieras

The Federal Reserve and Its Powers


1. Explain why the banking system was so unstable prior to the establishment of the Federal Reserve System in 1914.

Early in its history, the United States had two central banks that operated reasonably well by the standards of the day. However, American politics has always feared centralization of power and economic concentration, and central bankswere a prominent symbol of these fears. Both of these early central banks engaged in some minor political peccadilloes and as a result both banks died, between 1832 and 1914 the United States operated without the stable economic environment and effective payment system that a central bank offers to the nation.

Individual banks issued deposit liabilities and banknotes that served as the nation’smoney supply, however depending on the way a bank was viewed, its behavior on loans and issuing more money made that money lost its value and made commerce difficult because of the existence of so many different moneys. Also, private banks failed with some regularity during recessions, further contracting the money supply.

In summary the reasons why the banking system was so unstable were:* Unstable money supply
* No standard currency
* No coordinated payment system
* Unregulated banks
* No deposit insurance or minimum capital requirement
* No supervision of lending or accounting practices
* Frequent bank failures
* Disruptions of business credit from bank failures prolonged and intensified economic downturns
* Exaggerated businesscycle (boom and bust)

2. What is a call loan, and how did call loans contribute to economics recessions?

When large number of people simultaneously demanded the conversion of their paper money into hard currency, banks were forced to call in loans from their customers. At that time, most bank loans were called call loans, which are loans that are due when the bank calls and asks forrepayment.

The bank panics (when the public demanded more cash and the banking system ran short of cash and the economies experienced problems) caused the banks to act upon these call loans to face the public demand for cash. When business loans were called unexpectedly, many businesses failed because they had purchased with their loan money inventory and capital equipment that could not quicklybe converted to cash to pay the bank. Bank panics would spread, leading to large numbers of bank failures, which precipitated a large number of business failures as banks called more and more loans. The result was that the country would descend into a recession.

3. What were the four goals of the legislation that established the Federal Reserve System? Have they been met today?
Thepassage of the Federal Reserve Act in 1913 was meant to correct some of the shortcomings of the national bank system that became apparent during the severe financial crisis of 1907. The four goals of the legislations were to establish:
I. A monetary authority that would expand and contract the nation’s money supply according to the needs of the economy
II. A lender of last resort thatcould furnish additional funds to banks in times of financial crisis
III. An efficient payment system for clearing and collecting checks at par (face value) throughout the country
IV. A more vigorous bank supervision system to reduce the risk of bank failures.

Over the years, the goals and role of the Federal Reserve System have changed with the changing political and economicenvironment.

4. Explain why the Board of Governors of the Federal Reserve System is considered so powerful. What are its major powers, and which is the most important?
At the head of the Federal Reserve System is the seven member Board of Governors headquarters in Washington, D.C. Because the Board of Governors sets the nations monetary policy, the Board is among the most powerful of all...