11

Central Banks and the Federal Reserve System

Chapter 13

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The Price Stability GoalThe Price Stability Goal Low and stable inflationLow and stable inflation

InflationInflationCreates uncertainty and difficulty in planning for Creates uncertainty and difficulty in planning for

the futurethe futureLowers economic growthLowers economic growthStrains social fabricStrains social fabric

Nominal anchor to contain inflation Nominal anchor to contain inflation expectationsexpectations

Time-inconsistency problemTime-inconsistency problem

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Other Goals of Monetary Other Goals of Monetary PolicyPolicy

High employmentHigh employment

Economic growthEconomic growth

Stability of financial marketsStability of financial markets

Interest-rate stabilityInterest-rate stability

Foreign exchange market stabilityForeign exchange market stability

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Should Price Stability be the Should Price Stability be the Primary Goal?Primary Goal?

In the long run there is no conflict between In the long run there is no conflict between the goalsthe goals

In the short run it can conflict with the In the short run it can conflict with the goals of high employment and interest-rate goals of high employment and interest-rate stabilitystability

Hierarchical mandateHierarchical mandate

Dual mandateDual mandate

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Origins of the Federal Origins of the Federal Reserve SystemReserve System

Resistance to establishment of a central Resistance to establishment of a central bankbank

Fear of centralized powerFear of centralized powerDistrust of moneyed interestsDistrust of moneyed interests

No lender of last resortNo lender of last resortNationwide bank panics on a regular basisNationwide bank panics on a regular basisPanic of 1907 so severe that the public was Panic of 1907 so severe that the public was

convinced a central bank was neededconvinced a central bank was needed

Federal Reserve Act of 1913Federal Reserve Act of 1913Elaborate system of checks and balancesElaborate system of checks and balancesDecentralizedDecentralized

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Federal Reserve SystemFederal Reserve System

Source:Source: Federal Reserve Federal Reserve BulletinBulletin..

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Federal Reserve BanksFederal Reserve Banks Quasi-public institution owned by private Quasi-public institution owned by private

commercial banks in the district that are commercial banks in the district that are members of the Fed systemmembers of the Fed system

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Federal Reserve BanksFederal Reserve Banks Member banks elect six directors for each district; three Member banks elect six directors for each district; three

more are appointed by the Board of Governorsmore are appointed by the Board of Governors Three A directors are professional bankersThree A directors are professional bankers Three B directors are prominent leaders from industry, labor, Three B directors are prominent leaders from industry, labor,

agriculture, or consumer sectoragriculture, or consumer sector Three C directors appointed by the Board of Governors Three C directors appointed by the Board of Governors

are not allowed to be officers, employees, or stockholders of are not allowed to be officers, employees, or stockholders of banksbanks

Designed to reflect all constituencies of the publicDesigned to reflect all constituencies of the public

Nine directors appoint the president of the bank subject Nine directors appoint the president of the bank subject to approval by Board of Governorsto approval by Board of Governors

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Policy Tools in the Federal Policy Tools in the Federal Reserve SystemReserve System

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Functions of the Federal Functions of the Federal Reserve BanksReserve Banks

Clear checksClear checks

Issue new currencyIssue new currency

Withdraw damaged currency from circulationWithdraw damaged currency from circulation

Administer and make discount loans to banks in Administer and make discount loans to banks in their districtstheir districts

Evaluate proposed mergers and applications for Evaluate proposed mergers and applications for banks to expand their activitiesbanks to expand their activities

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Functions of the Federal Functions of the Federal Reserve Banks Reserve Banks

Act as liaisons between the business community Act as liaisons between the business community and the Federal Reserve Systemand the Federal Reserve System

Examine bank holding companies and state-Examine bank holding companies and state-chartered member bankschartered member banks

Collect data on local business conditionsCollect data on local business conditions

Use staffs of professional economists to Use staffs of professional economists to research topics related to the conduct of research topics related to the conduct of monetary policymonetary policy

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Member BanksMember Banks All national banks are required to be members of All national banks are required to be members of

the Federal Reserve Systemthe Federal Reserve System

Commercial banks chartered by states are not Commercial banks chartered by states are not required but may choose to be membersrequired but may choose to be members

Depository Institutions Deregulation and Depository Institutions Deregulation and Monetary Control Act of 1980 subjected all Monetary Control Act of 1980 subjected all banks to the same reserve requirements as banks to the same reserve requirements as member banks and gave all banks access to member banks and gave all banks access to Federal Reserve facilitiesFederal Reserve facilities

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Board of Governors of the Board of Governors of the Federal Reserve SystemFederal Reserve System

Seven members headquartered in Seven members headquartered in Washington, D.C.Washington, D.C.

Appointed by the president and confirmed by Appointed by the president and confirmed by the Senatethe Senate

14-year non-renewable term14-year non-renewable term

Required to come from different districtsRequired to come from different districts

Chairman is chosen from the governors and Chairman is chosen from the governors and serves four-year termserves four-year term

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Duties of the Board of Duties of the Board of GovernorsGovernors

Votes on conduct of open market operationsVotes on conduct of open market operations

Sets reserve requirementsSets reserve requirements

Controls the discount rate through “review and Controls the discount rate through “review and determination” processdetermination” process

Sets margin requirementsSets margin requirements

Sets salaries of president and officers of each Sets salaries of president and officers of each Federal Reserve Bank and reviews each bank’s Federal Reserve Bank and reviews each bank’s budgetbudget

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Duties of the Board of Duties of the Board of Governors (cont’d)Governors (cont’d)

Approves bank mergers and applications Approves bank mergers and applications for new activitiesfor new activities

Specifies the permissible activities of bank Specifies the permissible activities of bank holding companies holding companies

Supervises the activities of foreign banks Supervises the activities of foreign banks operating in the U.S.operating in the U.S.

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Chairman of the Board of Chairman of the Board of GovernorsGovernors

Advises the president on economic policyAdvises the president on economic policy

Testifies in CongressTestifies in Congress

Speaks for the Federal Reserve System to Speaks for the Federal Reserve System to the mediathe media

May represent the U.S. in negotiations May represent the U.S. in negotiations with foreign governments on economic with foreign governments on economic mattersmatters

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Federal Open Market Federal Open Market Committee (FOMC)Committee (FOMC)

Meets eight times a yearMeets eight times a year

Consists of seven members of the Board of Consists of seven members of the Board of Governors, the president of the Federal Reserve Governors, the president of the Federal Reserve Bank of New York and the presidents of four Bank of New York and the presidents of four other Federal Reserve banksother Federal Reserve banks

Chairman of the Board of Governors is also Chairman of the Board of Governors is also chair of FOMCchair of FOMC

Issues directives to the trading desk at the Issues directives to the trading desk at the Federal Reserve Bank of New YorkFederal Reserve Bank of New York

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FOMC MeetingFOMC Meeting Report by the manager of system open market Report by the manager of system open market

operations on foreign currency and domestic operations on foreign currency and domestic open market operations and other related issuesopen market operations and other related issues

Presentation of Board’s staff national economic Presentation of Board’s staff national economic forecastforecast

Outline of different scenarios for monetary policy Outline of different scenarios for monetary policy actions actions

Presentation on relevant Congressional actionsPresentation on relevant Congressional actions Public announcement about the outcome of the Public announcement about the outcome of the

meetingmeeting

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Why the Chairman Really Why the Chairman Really Runs the ShowRuns the Show

Spokesperson for the Fed and negotiates Spokesperson for the Fed and negotiates with Congress and the Presidentwith Congress and the President

Sets the agenda for meetingsSets the agenda for meetings

Speaks and votes first about monetary Speaks and votes first about monetary policypolicy

Supervises professional economists Supervises professional economists and advisersand advisers

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How Independent is the Fed?How Independent is the Fed?

Instrument and goal independence. Instrument and goal independence. Independent revenueIndependent revenueFed’s structure is written by Congress, and Fed’s structure is written by Congress, and

is subject to change at any time. is subject to change at any time. Presidential influencePresidential influence

Influence on CongressInfluence on CongressAppoints membersAppoints membersAppoints chairman although terms are not Appoints chairman although terms are not

concurrentconcurrent

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European Central BankEuropean Central Bank

Patterned after the Federal ReservePatterned after the Federal ReserveCentral banks from each country play Central banks from each country play

similar role as Fed bankssimilar role as Fed banksExecutive BoardExecutive Board

President, vice-president and four other President, vice-president and four other members members

Eight year, nonrenewable termsEight year, nonrenewable termsGoverning CouncilGoverning Council

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DifferencesDifferences

National Central Banks control their own National Central Banks control their own budgets and the budget of the ECBbudgets and the budget of the ECB

Monetary operations are not centralizedMonetary operations are not centralized

Does not supervise and regulate financial Does not supervise and regulate financial institutionsinstitutions

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Governing CouncilGoverning Council

Monthly meetings at ECB in Frankfurt, Monthly meetings at ECB in Frankfurt, GermanyGermany

Twelve National Central Bank heads and Twelve National Central Bank heads and six Executive Board memberssix Executive Board members

Operates by consensusOperates by consensus ECB announces the target rate and takes ECB announces the target rate and takes

questions from the mediaquestions from the media To stay at a manageable size as new To stay at a manageable size as new

countries join, the Governing Council will countries join, the Governing Council will be on a system of rotationbe on a system of rotation

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ECB IndependenceECB Independence

Most independent in the worldMost independent in the worldMembers of the Executive Board have long Members of the Executive Board have long

termstermsDetermines own budgetDetermines own budgetLess goal independentLess goal independent

Price stabilityPrice stabilityCharter cannot by changed by legislation; Charter cannot by changed by legislation;

only by revision of the Maastricht Treatyonly by revision of the Maastricht Treaty

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Structure and Independence of Structure and Independence of Other Foreign Central BanksOther Foreign Central Banks

Bank of CanadaBank of CanadaEssentially controls monetary policyEssentially controls monetary policy

Bank of EnglandBank of EnglandHas some instrument independence.Has some instrument independence.

Bank of JapanBank of JapanRecently (1998) gained more independence Recently (1998) gained more independence

The trend toward greater independenceThe trend toward greater independence

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Central Bank BehaviorCentral Bank Behavior

Theory of bureaucratic behavior:Theory of bureaucratic behavior:objective is to maximize its own welfare objective is to maximize its own welfare which is related to power and prestigewhich is related to power and prestigeFight vigorously to preserve autonomyFight vigorously to preserve autonomyAvoid conflict with more powerful groupsAvoid conflict with more powerful groups

Does not rule out altruismDoes not rule out altruism

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Case for IndependenceCase for Independence

Political pressure would impart an Political pressure would impart an inflationary bias to monetary policyinflationary bias to monetary policy

Political business cyclePolitical business cycle

Could be used to facilitate Treasury financing Could be used to facilitate Treasury financing of large budget deficits: accommodationof large budget deficits: accommodation

Too important to leave to politicians—the Too important to leave to politicians—the principal-agent problem is worse for principal-agent problem is worse for politicianspoliticians

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Case Against IndependenceCase Against Independence

UndemocraticUndemocraticUnaccountableUnaccountableDifficult to coordinate fiscal and monetary Difficult to coordinate fiscal and monetary

policypolicyHas not used its independence Has not used its independence

successfullysuccessfully

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