For a primer on how the Federal Reserve was created and operates see FED 101 here . Here is a little summary taken from information at the linked site and some other articles.
Structure:The Federal Reserve System was created by the Federal Reserve Act in 1913 and has an unusual mixture of public and private elements. The Federal Reserve Board is the national component of the Federal Reserve System. The board consists of the seven governors, appointed by the president and confirmed by the Senate. Governors serve 14-year, staggered terms to ensure stability and continuity over time. The chairman and vice-chairman are appointed to four-year terms. The Board exercises broad supervisory control over the financial services industry, administers certain regulations, and oversees the nation's payments system. The Board oversees the activities of Reserve Banks, approving the appointments of their presidents and some members of their boards of directors. The Board sets reserve requirements for depository institutions and approves changes in discount rates recommended by Reserve Banks. The Board's most important responsibility is participating in the Federal Open Market Committee (FOMC) which conducts our nation's monetary policy; the seven governors comprise the voting majority of the FOMC, with the other five votes coming from Reserve Bank presidents.
A network of 12 Federal Reserve Banks and 25 branches make up the Federal Reserve System under the general oversight of the Board of Governors. Reserve Banks are the operating arms of the central bank. The Reserve Banks serve banks and the U.S. Treasury. A Reserve Bank is often called a "banker's bank," storing currency and coin, and processing checks and electronic payments. Reserve Banks also supervise commercial banks in their regions. As the bank for the U.S. government, Reserve Banks handle the Treasury's payments, sell government securities and assist with the Treasury's cash management and investment activities.
Approximately 38% of the 8,039 commercial banks in the United States are members of the Federal Reserve System. National banks must be members; state-chartered banks may join if they meet certain requirements. The member banks are stockholders of the Reserve Bank in their District and as such, are required to hold 3 percent of their capital as stock in their Reserve Banks.
The Federal Open Market Committee, or FOMC, is the Fed's monetary policymaking body. It is responsible for formulation of a policy designed to promote stable prices and economic growth. Simply put, the FOMC manages the nation's money supply. The voting members of the FOMC are the Board of Governors, the president of the Federal Reserve Bank of New York and presidents of four other Reserve Banks, who serve on a rotating basis. All Reserve Bank presidents participate in FOMC policy discussions. The chairman of the Board of Governors chairs the FOMC.
How does the Fed create money?The most frequently used tool the Fed has is open market operations - buying and selling previously issued U.S. Government securities. Watch how the Fed creates money in this simplified multiple deposit creation model . The Fed changes the money supply by increasing or decreasing reserves in the banking system through the buying and selling of securities. The changes in the money supply, in turn, affect interest rates. The Fed also sets the discount rate which is the rate charged by Federal Reserve Banks to depository institutions for short term loans. The last tool of monetary policy is the setting of reserve requirements for the banks. That's the portion of deposits the banks must maintain on deposit with the Fed or in the vaults. When the Fed wants to increase reserves it buys securities and pays for them by making a deposit to the account maintained by the Fed at the dealer's bank. When it wants to decrease reserves it sells securities and collects funds from those accounts. When it doesn't want to influence reserves it engages in repo transactions that reverse themselves in short periods.
What is happening now? As you can see from the chart above the Fed's balance sheet has been rapidly expanded to levels never before seen. Traditionally the Fed's activities consisted almost entirely of buying Treasury securities which ultimately ended up as cash held by the public. In December of 2007 85% of the Fed's assets were held in the form of Treasury securities, and 89% of its liabilities took the form of currency held by the non-bank public. A lot has changed since then. Fed wanted to make more loans to alleviate problems it saw in the credit market without creating any new money which would create inflation. The way the Fed sought to achieve this was to sell off its Treasury securities and replacing them with loans and alternative assets. So we have an unprecedented increase in other assets held by the Fed. It's a two trillion dollar gamble by Bernanke; or with the new TALP plan, that's probably a three trillion dollar gamble though its hard to keep track the way they disclose information. If Bernanke wins his bet the taxpayers owe nothing. If he loses, you and I and our kids get the bill. The taxpayers will be committed to borrow a sum equal to any losses and start making interest payments on that massive debt.
