Functions of the Federal Reserve I

One key function of the Fed is clearing interbank payments.

For example, Tom pays $1,000 to his plumber. However, Tom’s account is at Bank A, while the plumber’s account is at Bank B.

So what happens between the banks? Bank B needs to collect $1,000 from Bank A.

This is where the Fed steps in.

To settle the payment, Bank A sends an instruction to the Fed through one of its electronic payment systems.

This instruction tells the Fed to move $1,000 from Bank A's reserve account to Bank B's reserve account.

To make this system work, commercial banks hold accounts at the Federal Reserve.

These are called 'master accounts,' and this is where banks hold their reserves—the funds that are used to settle payments between them.

In our example, the Fed debits, or reduces, Bank A’s master account by $1,000 and credits, or increases, Bank B’s master account by the same amount.

That means money has moved between banks at the Fed.

Bank B then credits the plumber’s account with $1,000.

What about Tom? His account at Bank A is debited at the initiation of the payment.