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Pedestrians walk past the Federal Reserve Building in Washington, D.C. Photo by Joshua Roberts/Reuters

How the Federal Reserve works

The Federal Reserve is the United States’ central banking system, but what that actually entails can be hard to grasp.

The best way to think about it is through three core functions, says Mary Daly, the president of the Federal Reserve of San Francisco.

1. A safe and sound payment system

“Basically we manage the cash operations and the currency. Your dollar in your wallet is something that we’re going to process. We’re going to ask, ‘Is it fit for duty? Can it be circulated and or does it have to be destroyed. And where do we have cash around the country?’ That’s a lot of our logistical work–where do we have cash in supply so that when people need currency they can get access to it?” Daly said.

The Federal Reserve doesn’t actually print money; that’s the Treasury’s job.

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But the Fed manages where and how money is distributed. “The Feds are thinking about how do we get people the cash supply they need so that they can do their trade.”

“When we’re doing our best work, whether it’s in the payment system or in bank supervision or in monetary policy, people don’t know we’re there. When we don’t, things falter and people are aware of us,” she added.

2. Bank supervision and regulation

The Fed isn’t the only bank regulator, but it does partner with a variety of other agencies to supervise and regulate banks and other financial institutions.

“The job is to make sure we’re looking into institutions that are part of our financial exchange so that we’re certain or as assured as we can be that they’re safe, they’re sound,” Daly said. The Fed also ensures that people who deposit their money can withdraw it and that the financial institutions’ lending practices are “fair and reasonable and compliant” with federal regulations.

If financial institutions suddenly fail, or there’s a crash, the Fed also acts as the “lender of last resort,” as it did during the 2008 financial crisis. The Federal Reserve allowed financial institutions to borrow hundreds of billion of dollars when banks stopped trusting and lending to each other.

That injected liquidity, but also stability, into the market because if Americans ever lose trust that they can access their money, “then panic ensues, everybody tries to get all their money out and the entire financial system is at risk,” Daly said.

3. Monetary policy

“Monetary policy is the tool kit,” Daly said. “The goal is to promote the foundation for a strong, healthy and sustainable economy.”

That means striking a balance between an economy that’s too hot, and one that’s too cold.

A “strong, healthy and sustainable economy” rests on two factors–low, steady inflation and full employment. Maintaining those is what is known as the Fed’s “dual mandate.”

The Fed needs to make sure inflation isn’t running away — eroding the value of the dollar and overheating the economy — and also that the economy is supported in a way that “everybody who can work and wants to work is engaged in the labor force,” Daly said.

Lee Koromvokis and Paul Solman contributed to this report.