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Definition

The Federal Reserve System is the central bank of the United States.

It performs five general functions to promote the effective operation of
the U.S. economy and, more generally, the public interest. The Federal
Reserve:

  • conducts the nation’s monetary policy to promote maximum
    employment, stable prices, and moderate long-term interest rates in
    the U.S. economy;
  • promotes the stability of the financial system and seeks to
    minimize and contain systemic risks through active monitoring and
    engagement in the U.S. and abroad;
  • promotes the safety and soundness of individual financial
    institutions and monitors their impact on the financial system as a
    whole;
  • fosters payment and settlement system safety and efficiency
    through services to the banking industry and the U.S. government
    that facilitate U.S.-dollar transactions and payments
  • promotes consumer protection and community development through consumer-focused supervision and examination, research
    and analysis of emerging consumer issues and trends, community
    economic development activities, and the administration of consumer
    laws and regulations.

Established by Congress in 1913, the Fed is composed of a Washington D.C.-based Board of Governors, twelve large regional banks, and a number of smaller affiliated institutions.

The Federal Reserve of the United States has a number of methods for influencing the American money supply. Chief among these is the power of the Fed to increase or decrease the amount of currency in circulation.

The Fed can purchase or sell government securities to its primary traders, which brings additional Federal Reserve Notes into circulation or removes excess paper money from the supply. The Fed also works with the U.S. Mint to print additional paper money, or to destroy unneeded currency.

Another of the Fed’s financial powers is its ability to influence the short-term interest rate. The Fed does this by changing the default rate at which it loans money to fellow banks.

Since the Fed’s default rate is one of the major factors in determining the nationwide prime interest rate, the Fed’s actions can indirectly increase or decrease the yield from interest-accruing assets. This in turn plays a role in determining investor behavior, and the trends of the market as a whole.

In more detail, the rate that the Fed lends money to depository institutions is called the Discount Rate. That is set above the ”nominal rate” which is the rate that the depository institutions lend money to each other to meet reserve requirements at the Fed. The nominal rate is what is commonly known as the Federal Funds Rate. It is set by open market operations.

Since the money supply is a factor in determining the overall trade balance between currency markets, foreign exchange traders who work with US currency tend to keep a close eye on the actions of the Federal Reserve.