Monetary Policy and The Federal Reserve System


The 2007 – 2009 financial crisis brought increased attention and scrutiny to the Federal Reserve System.  However, despite the Federal Reserve’s increased recognition, few in the public understand much about the institution.


The Federal Reserve System (the Federal Reserve or “the Fed”) is the central bank responsible for implementing monetary policy – the management of money and interest rates – in the U.S.  The Federal Reserve has a “dual mandate” of promoting stable prices and maximum employment.  The Federal Reserve attempts to achieve these objectives through three primary policy tools: reserve requirements, discount lending, and open-market operations.  While the Federal Reserve has several other responsibilities, such as overseeing the payments system and regulating banks, this chapter will focus on the Federal Reserve’s role in achieving its dual policy objectives by influencing the supply and cost of credit.



The Federal Reserve was the U.S.’s third attempt at establishing a central bank.  The first two central banks, the First Bank of the United States and the Second Bank of the United States, both lost political support and had their charters revoked in 1811 and 1836, respectively.


Although the country entered a period of industrial expansion in the mid-to-late 19th century, the country faced frequent banking panics.  During this time, banks were especially vulnerable to “runs”, where many depositors would demand their deposits simultaneously.  To meet the demand for currency, banks would liquidate assets, often at deeply discounted prices.  A vicious cycle would ensue, as these liquidations further weakened the financial position of banks and triggered even more deposit runs.  Various institutions would at times provide liquidity to the banking system during such panics.  For example, many clearing houses – the organizations responsible for facilitating and overseeing transactions among banks – periodically acted as de-facto central banks by pooling the reserves of its members and providing credit to those institutions most in need.  However, these institutions were limited in their resources and authority.


In addition to frequent bank panics, the early years after the collapse of the Second Bank of The United States saw the issuance and circulation of numerous currencies.  During this period, banks were state-chartered.  Bank-issued notes circulated as currency, and numerous banks meant numerous forms of currency (not all of which were trust-worthy).  By the time of the Civil War, the Chicago Tribune noted 8,370 different forms of notes in circulation.[1]  In 1863, Congress passed the National Bank Act, which allowed banks to apply for a national bank charter.  The legislation also allowed banks to issue National Bank Notes as a form of uniform, national money.[2]  The U.S. government further moved towards a uniform currency when it imposed a 10% tax on the issuance of state bank notes, making it unprofitable for state-chartered banks to issue notes.[3]  Although National Bank Notes became widely accepted as a national currency, the quantity of notes in circulation had little relation to the production of goods and services.[4]  Bank panics were still frequent occurrences after the passage of the National Bank Act.


In 1907, the country faced a severe financial crisis.  In October of that year, news emerged that the president of the Knickerbocker Trust was associated with a corrupt speculator who had used a controlling interest in a small financial institution, the Mercantile National Bank, in a failed attempt to seize control of a mining company.[5]  While the Mercantile was likely too small to pose a threat to the broader financial system, Knickerbocker was a well-known and relatively large institution.  Trust banks existed outside of National Banking regulations and, therefore, kept much smaller reserves.[6]  When the Knickerbocker faced a weeks-long run in late October, the outflow of deposits forced the trust to suspend operations.[7]  The run at the Knickerbocker led to runs at other financial institutions, igniting a full financial panic.  The panic was eventually halted when a consortium led by financier J.P. Morgan provided emergency loans to the Knickerbocker and other at-risk, but solvent, institutions.  However, the panic of 1907 underlined the need for the nation to have a central bank to act as a “lender of last resort” (provide emergency funds to financial institutions).


2.1.  The Federal Reserve Act

In 1908, Congress passed the Aldrich-Vreeland Act which established the National Monetary Commission to study weaknesses in America’s banking system.[8]  Senator Nelson Aldrich (R), the earliest major political proponent of a central bank, led the eighteen-member commission on a tour of European central banks.


In November 1920, Aldrich organized a secretive trip with a select group of advisers to Jekyll Island, Georgia.  This meeting, the secretive nature of which would become fodder for conspiracy theorists, was meant as a working group to establish a framework for central bank legislation.[9]  The plan, which was originally drafted at Jekyll Island and became known as the “Aldrich Plan”, was not submitted to Congress until 1912.  By this time, Aldrich had retreated from political life and the Democrats had taken control of the Presidency and Congress.  Lacking political support, the Aldrich Plan withered.  However, the Aldrich Plan, which called for a National Reserve Association, shared many similarities with the eventual Federal Reserve Act.


Although the Aldrich Plan was a legislative failure, the cause of establishing a central bank was taken up by a Congressman from Virginia named Carter Glass.  It was Glass’s bill which, once reconciled with the Senate’s version, gained the endorsement from President Woodrow Wilson.


The Federal Reserve was established on December 23, 1913, when President Woodrow Wilson signed into law the Federal Reserve Act.  Although the final law was the product of much debate and political theatre, it was also a recognition that despite America’s growing industrial prowess, the country’s financial system had fallen behind that of other industrialized nations.


The American populace was largely distrustful of financial centralization.  As such, the Federal Reserve was meant to be a decentralized, regional system calling for eight to twelve district banks.  A committee was established to determine the specific cities and district boundaries for the new reserve banks, eventually settling on twelve districts.[10]


The Federal Reserve’s early mandate was to act as a “lender of last resort”.  Although the Federal Reserve Act created a new national currency in the form of Federal Reserve notes, price-stability was not a major concern, as the drafters assumed the Federal Reserve would act in a manner consistent with the gold standard.[11]  The Federal Reserve’s primary tool for providing liquidity to member banks was discounting, i.e., purchasing a loan at a discount from the loan’s face value.  In addition, the early Federal Reserve followed the “real bills” doctrine, which focused on loans for productive enterprise under the assumption that reserves lent against such loans would not be inflationary.[12]  Thus, the policy tools of the early Federal Reserve were limited.  As we will see, both the structure of the Federal Reserve and its tools for conducting monetary policy would greatly evolve.


According to legal scholar Peter Conti-Brown, the Federal Reserve System should be thought of as having multiple foundings, or major events which shaped the institution.  Conti-Brown identifies the “three foundings of the Federal Reserve” as: The Federal Reserve Act of 1913, The Banking Act of 1935, and the Fed-Treasury Accord of 1951.[13]  To these three events, I would add two more: the inflationary period of 1965-1982 (known as the “Great Inflation”), and the ensuring period known as the “Great Moderation”.


2.2.  Depression-Era Reforms

The legal restrictions placed upon the Federal Reserve from its founding legislation, along with the Federal Reserve’s initial decentralized structure, limited the institution’s effectiveness in fighting the economic crisis.  During the depression, several pieces of legislation were passed to restructure and broaden the operations of the Federal Reserve.  Banking Acts were passed in 1932, 1933, and 1935.  The Banking Act of 1935, however, was the most far-reaching in restructuring the Federal Reserve’s governance and operations.


The Banking Act of 1935 made numerous changes to the Federal Reserve’s structure.  The original Federal Reserve Board, which oversaw the autonomous operations of each district bank, was restructured into a Board of Governors.  The Federal Reserve also became more independent of the executive branch, as the Treasury Secretary and Comptroller of the Currency were not included as members of the new Board of Governors.[14]


The 1935 Banking Act also had a lasting impact on the conduct of monetary policy.  The Federal Open Market Committee (FOMC), which was established in the 1933 Banking Act, was restructured to limit the participation of the district banks to four rotating seats.  Thus, the voting members of the FOMC consisted of the seven-member Board of Governors, the president of the Federal Reserve Bank of New York, and four rotating seats held by the district bank presidents, a structure which persists to this day.[15]


2.3.  The Fed-Treasury Accord

After the United States entered World War II in December 1941, the independence of the Federal Reserve was superseded by the Treasury Department’s war-funding needs.  At the request of the Treasury, the Federal Reserve agreed to aggressively purchase government securities to keep the Treasury’s borrowing costs at 3/8 percent for short-term bills and 2.5 percent for longer-term Treasury bonds.[16]


The Federal Reserve’s war-time policy proved highly inflationary, with consumer prices reaching an annualized rate of 21 percent by 1951.[17]  The Federal Reserve openly sought to end the agreement with the Treasury, but faced harsh resistance from the Truman administration, who by that time was facing an open war in Korea.  After months of conflict between the Truman administration and the Federal Reserve, the two sides reached an agreement where the Federal Reserve agreed to temporarily support the price of five-year notes but eventually let prices for medium and long-term bonds fluctuate freely.[18]  This agreement, known as the Fed-Treasury Accord, set a precedent for the Federal Reserve’s independence from the government’s funding needs.


2.4.  Inflationary Period

The period from 1965 through 1982 was characterized by persistently high inflation, relatively low economic growth, and relatively high unemployment.  This period, much like the great depression, represented an important economic period which would force a rethinking of then widely-accepted economic theories.


I will here define inflation as a persistent increase in the general level of consumer prices caused by an increase in the supply of money which exceeds the increase in the production of goods and services.  In other words, inflation is too much money chasing too few goods.  During this period, however, the Federal Reserve largely ignored growth in the money supply.


The post-war Federal Reserve was under the leadership of Chairman William McChesney Martin.  Martin remains the longest-running Chairman of the Federal Reserve, having served in that role from 1951 to 1970.  For most of Martin’s tenure, inflation remained relatively low.  However, inflation began to increase in 1965 and persisted through the end of Martin’s tenure in 1970.


Under Martin, the Federal Reserve focused on the level of bank reserves and short-term interest rates but paid little attention to the total money supply.[19]  In other words, the link between the money supply and prices was not appreciated.  In addition, Martin at times bowed to political pressure to “coordinate policy” with the Johnson administration.[20]


In 1970, Arthur Burns became Chairman of the Federal Reserve Board, the first professional economist to hold that position.  But Burns also proved ineffective at fighting runaway inflation.  Burns presided as Chairman until 1978 at which time he was replaced by William Miller, an industrialist who was neither professionally nor temperamentally suited for the job.[21]  However, Miller was offered, and accepted, a position as Treasury Secretary in the Cater administration.  Miller thus resigned his position with the Federal Reserve in the summer of 1979.  He was replaced by Paul Volker, a professional economist who was then serving as President of the New York Federal Reserve.  It was under Volker’s leadership that the Federal Reserve finally brought inflation under control.


2.4.1.  The Collapse of Bretton Woods

One of the seminal events during this period was the breakdown of a global currency arrangement known as the Bretton Woods Agreement (named after the town in New Hampshire where the agreement was negotiated in 1944).  Under this arrangement, international currencies were set at a fixed-rate (“pegged”) to the U.S. dollar, with the dollar in turn anchored to the price of gold at $35 per ounce.  The Bretton Woods system was not a complete gold standard (did not allow domestic citizens to convert dollars into gold), but rather allowed foreign countries to convert their dollar holdings into gold.  This arrangement brought a degree of monetary restraint, as the U.S. was responsible for maintaining the value of the dollar to prevent a run on its gold supply.  However, the supply of foreign-held dollars eventually exceeded the country’s gold supply.  In the summer of 1971, President Richard Nixon announced a halt to gold convertibility, effectively ending the Bretton Woods arrangement.


2.4.2.  The Intellectual Context of the Great Inflation

Economic policy in the ensuing several decades after World War II was highly influenced by the work of late British economist John Maynard Keynes, who promoted the aggressive use of tax and spending policies (fiscal policy) to counteract recessions.  Keynes’s work was furthered by many economists in the U.S. and Europe in a collection of viewpoints which became known as Keynesian stabilization policy.


Keynesian stabilization promoted coordination between fiscal and monetary policy under a trade-off theory known as the Phillips curve.  The Phillips curve assumed a long-term tradeoff between inflation and unemployment, i.e., unemployment could be lowered by increasing inflation.[22]  However, several economists, most notably University of Chicago economist Milton Friedman, warned that the Phillips curve tradeoff was only a short-term bargain which would lead to much higher long-term inflation regardless of the level of employment.[23]


The Employment Act of 1946 established the responsibility of the government to promote maximum employment.[24]  This law became the basis for the Federal Reserve’s current “dual mandate” of price stability and maximum employment.  However, the Federal Reserve under Burns chose to prioritize maximum employment, even at the risk of higher inflation.[25]  In addition, Burns largely blamed inflation on “cost-push” factors, i.e., increases in cost inputs which would lead to higher producer and consumer prices.[26]  Given the two oil price shocks in the 1970’s, in which oil prices quadrupled and tripled, respectively, the cost-push theory seemed plausible to many at the time.[27]


2.4.3.  Volcker’s Fight Against Inflation

Seemingly little changed in Fed policy during William Miller’s brief tenure.  However, Miller was succeeded by Paul Volker in the summer of 1979, and Volker was determined to rein in prices, which by that time had been increasing at annual double-digit rates.  In addition, unemployment was relatively high and economic output relatively low.  The combination of high inflation and high unemployment was a condition referred to as “stagflation”.  This was a condition which should not have occurred according to the Keynesian models.


By this time, the role of the money supply as a cause of inflation was becoming increasingly accepted.  In 1978, Congress passed the Full Employment and Balanced Growth Act (the “Humphrey-Hawkins” Act), which more explicitly mandated the Federal Reserve to pursue full employment and price stability as its central objectives and required the Fed to establish targets for the growth in the money supply.[28]  The legislation also required the Federal Reserve Chairman to periodically testify to Congress, thus making Volker a more visible Fed Chairman than his predecessors.


In October of 1979, Volker announced that the Federal Reserve would more explicitly target monetary growth to fight inflation.  The FOMC would do this by managing the level of bank reserves, and thus letting interest rates fluctuate freely in accordance with the restricted supply of credit.[29]  This was in contrast to previous policy (in the late 1970’s) in which the Fed set targets for both various money supply measures and the federal funds rate (the rate banks charge each other on overnight loans), with the Fed leaving ambiguous which measures they would prioritize.[30] Volker understood that the Fed’s inflation-fighting credibility had been compromised during this period, and he sought to restore confidence in the Federal Reserve.


By targeting the money supply directly, interest rates became highly volatile.  In April of 1980, the Federal Funds rate reached an average of 17.6%, came down dramatically, and then increased again to a peak of over 20% in the summer of 1981.[31]  This interest rate volatility led to recessions in 1980 and again in 1981-1982.  The 1981-82 recession, which lasted from July 1981 to November 1982, was particularly severe, with overall unemployment reaching a high of 11%.  In interest-rate sensitive industries, such as auto manufacturing and homebuilding, unemployment reached well over 20%.[32]


Despite the severe recessions, the Fed’s efforts to tame inflation were successful, with the inflation rate falling to 3.7 in 1983.[33]  With inflation largely in check, the Fed deemphasized money supply growth and returned to targeting interest rates.[34]


2.5.  The Great Moderation

The change in monetary policy and the restoration of the Federal Reserve’s credibility in the Volker years cannot be overstated.  Volker set a precedent for future Fed policy when he prioritized price stability and interpreted price stability as being necessary to the objective of maximum employment.


The ensuing period after the inflationary period has become known as “the Great Moderation”.  This period is characterized by mostly uninterrupted economic growth and low inflation.  The period of the Great Moderation is thought to have ended in 2007, when the Federal Reserve began to focus its efforts on fighting a spreading financial crisis.[35]


In 1987, Paul Volker was succeeded as Fed Chairman by Alan Greenspan.  Chairman Greenspan continued to deemphasize money supply measures and testified to Congress in 1993 that the Fed would no longer use monetary targets as a policy guide.[36]  Greenspan also improved the Federal Reserve’s communication and policy guidance.  Despite relatively stable economic growth and consumer prices, this period saw several large asset-price bubbles.  The role of monetary policy in these asset-price bubbles continues to be debated.




The Federal Reserve System is primarily composed of twelve regional Federal Reserve banks, the Federal Reserve Board of Governors, and the Federal Open Market Committee (FOMC).


3.1.  The Federal Reserve Banks

The twelve Federal Reserve banks are scattered throughout the country, with each one representing a certain district.  The district banks are housed in the following twelve cities: San Francisco, Dallas, Kansas City, Minneapolis, St. Louis, Chicago, Atlanta, Richmond, Cleveland, Philadelphia, New York, and Boston.


The Reserve Banks are quasi-private entities in that their ownership and governance structures are a blend of government and private interests (the member banks must hold stock in the district bank as a requirement of membership).  Each member bank has a president who is nominated by the reserve bank’s directors and must be approved by the Board of Governors.


3.2.  Federal Reserve Board of Governors

The Board of Governors is a seven-member governing body located in Washington D.C.  Each member, referred to as a “Governor”, is nominated by the President of the United States and confirmed by the Senate.  The appointments are for 14-year periods and are staggered so that an appointment expires every other year.


One Governor is chosen by the U.S. President to serve as Chair (Chairman or Chairwoman) of the Board of Governors.  Another governor is chosen by the President to serve as Vice Chair.  Both the Chair and Vice Chair appointments are for four-year terms, and the Chair and Vice Chair must both be confirmed by the Senate.  If the Chair or Vice Chair are not already members of the Board of Governors, they will be simultaneously appointed to the Board at the time of their appointment.  If the Chair or Vice Chair is not reappointed by the President, they are expected to also resign their post as governor, even if their 14-year term has not expired.


3.3.  The FOMC

The Federal Open Market Committee (FOMC) is responsible for setting monetary policy.  The FOMC has twelve voting members, consisting of the seven-member Board of Governors, the president of the New York Federal Reserve, and four district bank presidents serving on a one-year rotating basis.  The remaining district bank presidents participate in discussions at FOMC meetings, but do not have a formal vote.  By tradition, the Chair of the Board of Governors serves as the FOMC Chair and the president of the New York Federal Reserve serves as the FOMC Vice Chair.




The Federal Reserve has three primary tools for conducting monetary policy:  setting reserve requirements, lending to member banks through the “discount window”, and open market operations.  The Federal Reserve was recently given a fourth tool, the ability to pay interest on deposits held at the Federal Reserve.  However, this fourth tool has yet to be widely used and we thus omit it from this discussion.


4.1.  Reserve Requirements

All depository institutions are required by law to hold a certain amount of deposits as reserves.  The Federal Reserve is responsible for establishing these reserve requirements.  The Fed could decrease the money supply by increasing reserve requirements and, conversely, increase the money supply by decreasing the reserve requirement.  The relationship between required reserves and the money supply can be seen through a concept known as the money multiplier.  Mathematically, the money multiplier is 1 / reserve ratio.  The reserve ratio for large banks is currently 10%.  This means that each new dollar of deposits to a large bank can potentially increase the money supply by $1 / .10 = $10.  The reserve requirement is a seldom-used tool for monetary policy, and the required reserve ratio has remained relatively fixed for the last several decades.


4.2.  Discount Window Lending

The Fed’s “discount window” is a mechanism where the Fed lends to member banks, usually on an overnight basis.  The loans are made at a discount to the maturity value of the loan, with the difference representing the interest the Fed charges (the discount rate).  To discourage overuse of the discount window, the Fed normally charges a rate slightly higher than the federal funds rate.


Discount window lending is not a widely-used tool for monetary policy but is an important mechanism for the Fed’s role as “lender of last resort” during a financial crisis.


4.3.  Open Market Operations

Member banks at the Federal Reserve keep reserves on account at their respective Federal Reserve banks.  The Federal Reserve requires banks to keep a certain level of total reserves (reserves at the Fed plus currency held in vaults).  Some banks hold more reserves than legally required, while other banks have temporary shortfalls in total reserves.  Those banks who hold more reserves than required can lend those reserves to other member banks (overnight) through the federal funds market.  The rate which these banks charge is referred to as the federal funds rate.  It is this rate which the Federal Reserve targets when setting monetary policy.


By influencing the supply of reserves in the banking system, the Federal Reserve can increase or decrease the federal funds rate.  When the Federal Reserve wants to lower the federal funds rate, it purchases short-term U.S. Treasury securities from member banks and pays for the purchases by increasing the reserves of those banks.  The increased supply of reserves lowers the rate which banks charge in the federal funds market.  When the Federal Reserve wants to increase the federal funds rate, it sells U.S. Treasury securities to member banks and accordingly decreases the reserves of those banks.  The decreased supply of reserves increases the rate which banks charge in the federal funds market.  This process of buying and selling Treasury securities to influence the federal funds rate is referred to as open market operations and it is the Federal Reserve’s most widely used tool for achieving monetary objectives.



5.1.  Inflation

Earlier in this chapter, I stated that inflation is too much money chasing too few goods.  More generally, inflation is a persistent decline in the purchasing power of a country’s currency caused by too much money in circulation.  Inflation is measured by the Consumer Price Index (CPI), an index constructed from monthly price surveys conducted by the Bureau of Labor Statistics.  The CPI is a “basket” of goods and services which are likely to be consumed by an average family.  The goods and services in the basket are periodically updated to reflect changing consumer preferences and technological change.


Inflation creates many problems for a country’s economy.  For one, inflation makes it difficult for firms and households to plan for the future.  Inflation also punishes thrift and saving.  Imagine having saved $1000.  In a year of 10% inflation, that same $1000 in one year will only purchase 90% of what it could purchase at the beginning of the year.  There is not much incentive to save in an inflationary economy, so consumers spend their money as quickly as possible.  This increase in the rate of spending is referred to as the “velocity” of money, and this also contributes to increased inflation.


High inflation can adversely impact a country’s financial system.  Inflation facilitates a transfer of wealth from savers to borrowers.  Many forms of borrowing, such as many residential mortgages, have fixed interest rates.  Borrowers of such loans thus pay them back with depreciated currency.  In other words, inflation decreases the real value of fixed debts.  Suppose a borrower has a mortgage with a fixed 6% interest rate.  If the inflation rate rises to 8%, the real rate of interest is -2% (the fixed rate of 6% minus the 8% inflation rate).  To further complicate matters for lenders, many financial institutions finance their loans with short-term liabilities of various forms.  As inflation expectations rise, the interest rates on these short-term liabilities increase.  Many institutions can even see their funding costs exceed the returns on their loans, which is what occurred to the savings and loan industry (S&Ls) in the late 1970’s and early 1980’s.


Inflation in its most extreme form is known as hyperinflation.  Many will recall seeing pictures of post-World War I Germans using paper currency as heating fuel.  The German government, in an effort to decrease the value of war reparations, inflated the currency to the point where it was valued more highly as a source of fire than as a medium of exchange.


5.2.  Deflation

Deflation is the persistent decrease in the aggregate price level.  In a deflationary economy, purchasing power actually increases.  While this may sound nice on the surface, persistent deflation can devastate a nation’s economy.


The main problems with deflation is that it (a) increases the real value of fixed debts, (b) increases the real rate of interest borrowers must pay, and (c) decreases the value of the collateral backing the loans.  Consider, for example, the above-mentioned mortgage with a fixed 6% interest rate.  If deflation is 5%, then the real interest rate paid by this borrower is 11% (the 6% fixed rate plus the 5% deflation rate).  Consider two more likelihoods of this scenario.  First, the value of the property backing the mortgage is likely declining, meaning the borrower possibly owes more than what the property is worth (the borrower is “underwater”).  Second, the borrower’s income is also likely declining.  This is a recipe for a default by the borrower.  Extrapolate this scenario across an entire economy, and we notice a dangerous feedback loop: high loan defaults lead to asset liquidations at depressed prices, which increases defaults further, which lead to more liquidations, etc.  This is what happened during America’s Great Depression, and this is what the Federal Reserve was trying to prevent in the fall of 2008.





In 2006, Alan Greenspan was succeeded as Chairman of the Federal Reserve’s Board of Governors by Ben Bernanke, an academic economist who was a noted scholar of the Great Depression and other global financial crises.  When the severity of the financial crisis became apparent, Bernanke and his Fed colleagues were committed to doing everything they could to combat it.  Invoking emergency powers under Section 13(3) of the Federal Reserve Act, the Fed went far beyond its normal tools of monetary policy to prevent a spread of financial panic and stabilize the economy.[37]


The actions of the Federal Reserve both during and after the financial crisis were vast, and largely beyond the scope of the discussion presented in this section.  I should also note that fiscal policy, under both the Bush and Obama administrations, was highly active during this period, but I have chosen to omit any discussion of these actions.  My only intention in this section is to provide an overview of the extraordinary response from the Fed, acting in its role as “lender of last resort”.


6.1.  Federal Reserve Actions During the Financial Crisis

In the early years of the new millennium, the country entered a period of aggressively rising home values and increasing home ownership rates.  This housing boom was driven largely by low interest rates and a wave of financial innovation.  During this period, mortgage backed securities (MBS) – instruments in which home mortgages are pooled and used as collateral for the issuance of bonds – proliferated.  However, global demand for such instruments led to a dramatic decline in the quality of the mortgages being pooled, with many mortgages being made to individuals with weak credit histories (“subprime” mortgages).  By 2006, many economists and market commentators voiced concerns that the country was in an unsustainable housing bubble, but few accurately predicted what the impact to the global financial system would be.


The housing bubble eventually burst, leading to a wave of mortgage defaults.  Many large financial firms had significant exposure to MBS and other opaque instruments tied to the mortgage market.  As the value of mortgage-related instruments declined, many of these financial firms found it difficult to finance their operations in wholesale credit markets.  In March of 2008, Bear Stearns, a large and venerable Wall Street investment firm, did not have enough cash on hand to fund operations and was forced to find a buyer for the firm.  In an eleventh-hour deal, J.P. Morgan Chase agreed to purchase Bear Stearns.  However, given the uncertainty of Bear Stearns’s mortgage assets, J.P. Morgan Chase would only agree to the deal if the government would provide a guarantee on the value of the assets. The Federal Reserve Bank of New York, which had been monitoring the Bear Stearns funding crisis, agreed to invoke emergency lending authority (approved by the Board of Governors in Washington) and finance a significant portion of the purchase.  The Federal Reserve’s role in the Bear Stearns acquisition was the first in a series of unprecedented actions taken during the financial crisis.


Shortly after the Bear Stearns acquisition, the Federal Reserve extended discount window lending to non-bank financial institutions.  However, the financial crisis continued to widen.   In September of 2008, Lehman Brothers, a financial firm significantly larger than Bear Stearns, was no longer able to fund its ongoing operations. With Lehman Brothers, however, neither the Federal Reserve nor the U.S. Treasury intervened.  Lehman Brothers filed for Bankruptcy on September 15, 2008.  The Lehman bankruptcy sent shock waves through the financial system.  Fearing an even greater spread of financial contagion, the Fed increased its emergency lending authority, even going as far as funding the U.S. Treasury’s purchase of 80% of insurer AIG.[38]  The Fed’s motivation in these extraordinary interventions was to prevent a full collapse of credit markets.


6.2.  Quantitative Easing

While the Federal Reserve provided support for several “systemically important” financial institutions, the Fed was also attempting to stimulate the economy in any way it could.  Fearing a sustained period of declining asset prices, a condition which occurred during and likely worsened the Great Depression, Bernanke and the Fed were committed to using the Fed’s “money printing” authority to purchase a variety of assets, such as MBS, which the Fed had not traditionally purchased.  These asset purchase programs became known as “quantitative easing (QE)”.


By this time, the Fed had reduced the federal funds rate to zero.  Thus, the Fed began to focus on reducing longer-term interest rates.  The Fed did this by purchasing longer-term assets through its QE program.  The Fed also communicated that it would leave the federal funds rate at or near-zero for a long period.  According to Bernanke, “Our goal was to bring down longer-term interest rates, such as the rates on thirty-year mortgages and corporate bonds.  If we could do that, we might stimulate spending – on housing and business capital investment, for example.”[39]



In this chapter, I have attempted to provide readers with a basic overview of the Federal Reserve System (the “Fed”).


The Federal Reserve as an institution has evolved significantly since its founding in 1913.  As we have seen, the institution’s structure, objectives, and policy tools have changed dramatically.  The Federal Reserve’s key objectives are price stability and full employment.  Because these objectives can be at odds, the Fed must balance these objectives, which it has done to various degrees over its history.


The Fed’s main monetary policy tool is known as open market operations.  Through this mechanism, the Fed targets a key short-term interest rate known as the federal funds rate.  By influencing the supply of loanable funds, the Fed can impact the expenditure and investment behavior of firms and households.


The Fed also serves as the “lender of last resort” during a financial panic.  The 2008 financial crisis increased the importance of this function of the Fed.



Axelrod, Stephen H.  Inside the Fed: Monetary Policy and its Management, Martin Through Greenspan to Bernanke.  Cambridge:  MIT Press, 2009.


Bernanke, Ben S.  The Courage to Act: A Memoir of a Crisis and its Aftermath.  New York: Norton, 2015.


Board of Governors of The Federal Reserve System.  The Federal Reserve System:  Purposes & Functions, 10th ed.  Board of Governors of the Federal Reserve System, 2016.


Bryan, Michael.  “The Great Inflation”,


Conti-Brown, Peter.  The Power and Independence of The Federal Reserve.  Princeton: Princeton University Press, 2016.


Federal Reserve Bank of Philadelphia.  The State and National Banking Eras: A Chapter in the History of Central Banking.  Federal Reserve Bank of Philadelphia, 2016.


Hakklo, Craig S.  “The Great Moderation”,


Lowenstein, Roger.  America’s Bank: The Epic Struggle to Create The Federal Reserve.  New York: Penguin Press, 2015.


Medley, Bill.  “Volker’s Announcement of Anti-Inflation Measures”,


Meltzer, Allan H.  “Origins of the Great Inflation.”  Federal Reserve Bank of St. Louis Review, Part 2  (March/April 2005): 145-176.


Mishkin, Frederic S.  The Economics of Money, Banking, and Financial Markets, 2nd ed.  Boston:  Addison-Wesley, 2010.


Moen, Jon R. and Ellis W. Tallman.  “The Panic of 1907”,


Richardson, Gary, Alejandro Komai, and Michael Gou.  “Banking Act of 1935”,


Romero, Jessie.  “Treasury-Fed Accord”,


Sablik, Tim.  “Recession of 1981-82”,


Walsh, Carl E.  “October 6, 1979.  Federal Reserve Bank of San Francisco Economic Letter, 2004-35 (December 2004).


Weinberg, John.  “Support for Specific Institutions”,


Wheelock, David C.  “The Fed’s Formative Years”,


[1] Lowenstein, America’s Bank, 12.

[2] Ibid., 13.

[3] Federal Reserve Bank of Philadelphia, The State and National Banking Eras, 12.

[4] Lowenstein, America’s Bank, 14.

[5] Moen and Tallman, “The Panic of 1907”.

[6] Lowenstein, America’s Bank, 61-62.

[7] Moen and Tallman, “The Panic of 1907”.

[8] Lowenstein, America’s Bank, 79.

[9] Ibid., 107-123.

[10] Wheelock, “The Fed’s Formative Years”.

[11] Lowenstein, America’s Bank, 230.

[12] Mishkin, The Economics of Money, Banking & Financial Markets, 484.

[13] Conti-Brown, The Power and Independence of the Federal Reserve, 15-39.

[14] Richardson, Komai, and Gou, “Banking Act of 1935”.

[15] Ibid.

[16] Romero, “Treasury-Fed Accord”.

[17] Ibid.

[18] Ibd.

[19] Axilrod, Inside the Fed, 36.

[20] Meltzer, “Origins of the Great Inflation,” 160.

[21] Axelrod, Inside the Fed, 78-89

[22] Bryan, “The Great Inflation”.

[23] Ibid.

[24] Ibid.

[25] Meltzer, “Origins of the Great Inflation,” 167.

[26] Ibid., 169.

[27] Bryan, “The Great Inflation”.

[28] Ibid.

[29] Medly, “Volcker’s Announcement of Anti-Inflation Measures”.

[30] Walsh, “October 6, 1979”, 2.

[31] Ibid., 2-3.

[32] Sabik, “Recession of 1981-82”.

[33] Medly, “Volcker’s Announcement of Anti-Inflation Measures”.

[34] Mishkin, The Economics of Money, Banking & Financial Markets, 490.

[35] Hakklo, “The Great Moderation”.

[36] Mishkin, The Economics of Money, Banking & Financial Markets, 491.

[37] Weinberg, “Support for Specific Institutions.”

[38] Ibid.

[39] Bernanke, The Courage to Act, 418.


By |April 13th, 2018|Money and Banking|

About the Author:

Matthew DePaola is a long-time practitioner of the deep value investing approach. He cofounded Tortuga Capital after having concluded that few institutional money managers follow a true value investing approach. Matthew has broad experience in business finance and asset valuation, and has engineered the leveraged purchase and recapitalization of several small businesses. Matthew has also spent several years as a financial analyst in the residential real estate development field. He earned his MBA from the University of Florida’s Hough Graduate School of Business and holds a BS in Finance from Florida Gulf Coast University.

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