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The Economics of Money, Banking, and Financial Markets

Fourth Edition

Chapter 16

Central Banks and the Federal Reserve System

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This chapter considers the structure and activities of central banks focusing primarily on the Federal Reserve System of the U.S.

Learning Objectives (1 of 2)

16.1 Recognize the historical context of the development of the Federal Reserve System.

16.2 Describe the key features and functions of the Federal Reserve System.

16.3 Assess the degree of independence of the Federal Reserve.

16.4 Identify the ways in which the theory of bureaucratic behavior can help explain Federal Reserve actions.

Learning Objectives (2 of 2)

16.5 Identify the similarities and distinctions in structure and independence between the European Central Bank and the Federal Reserve.

16.6 Assess the degree of independence of other major central banks around the world.

Origins of the Federal Reserve System

Resistance to establishment of a central bank

Fear of centralized power

Distrust of moneyed interests

No lender of last resort

Nationwide bank panics on a regular basis

Panic of 1907 so severe that the public was convinced a central bank was needed

Federal Reserve Act of 1913

Elaborate system of checks and balances

Decentralized

Structure of the Federal Reserve System (1 of 2)

The writers of the Federal Reserve Act wanted to diffuse power along regional lines, between the private sector and the government, and among bankers, business people, and the public.

Structure of the Federal Reserve System (2 of 2)

This initial diffusion of power has resulted in the evolution of the Federal Reserve System to include the following entities:

The Federal Reserve banks

The Board of Governors of the Federal Reserve System

The Federal Open Market Committee (FOMC)

The Federal Advisory Council

Around 2,900 member commercial banks

Figure 1 Structure and Responsibility for Policy Tools in the Federal Reserve System

Federal Reserve Banks (1 of 2)

Quasi-public institution owned by private commercial banks in the district that are members of the Fed system

Federal Reserve Banks (2 of 2)

Member banks elect six directors for each district; three more are appointed by the Board of Governors

Three A directors are professional bankers

Three B directors are prominent leaders from industry, labor, agriculture, or consumer sector

Three C directors appointed by the Board of Governors are not allowed to be officers, employees, or stockholders of banks

Designed to reflect all constituencies of the public

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

Figure 2 Federal Reserve System

Source: Federal Reserve Bulletin

Functions of the Federal Reserve Banks (1 of 2)

Clear checks

Issue new currency

Withdraw damaged currency from circulation

Administer and make discount loans to banks in their districts

Evaluate proposed mergers and applications for banks to expand their activities

Functions of the Federal Reserve Banks (2 of 2)

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

Examine bank holding companies and state-chartered member banks

Collect data on local business conditions

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

Federal Reserve Banks and Monetary Policy

Directors “establish” the discount rate

Decide which banks can obtain discount loans

Directors select one commercial banker from each district to serve on the Federal Advisory Council which consults with the Board of Governors and provides information to help conduct monetary policy

Five of the 12 bank presidents have a vote in the Federal Open Market Committee (FOMC)

Member Banks

All national banks are required to be members of the Federal Reserve System

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

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

Board of Governors of the Federal Reserve System

Seven members headquartered in Washington, D.C.

Appointed by the president and confirmed by the Senate

14-year non-renewable term

Required to come from different districts

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

Duties of the Board of Governors (1 of 2)

Votes on conduct of open market operations

Sets reserve requirements

Controls the discount rate through “review and determination” process

Sets margin requirements

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

Duties of the Board of Governors (2 of 2)

Approves bank mergers and applications for new activities

Specifies the permissible activities of bank holding companies

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

Chairman of the Board of Governors

Advises the president on economic policy

Testifies in Congress

Speaks for the Federal Reserve System to the media

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

Federal Open Market Committee (FOMC)

Meets eight times a year

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

Chairman of the Board of Governors is also chair of FOMC

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

Inside the Fed: The FOMC Meeting

Report by the manager of system open market operations on foreign currency and domestic open market operations and other related issues

Presentation of Board’s staff national economic forecast

Outline of different scenarios for monetary policy actions

Presentation on relevant Congressional actions

Public announcement about the outcome of the meeting

Why the Chairman of the Board of Governors Really Runs the Show

Spokesperson for the Fed and negotiates with Congress and the President

Sets the agenda for meetings

Speaks and votes first about monetary policy

Supervises professional economists and advisers

How Independent is the Fed?

Instrument and goal independence.

Independent revenue

Fed’s structure is written by Congress, and is subject to change at any time.

Presidential influence

Influence on Congress

Appoints members

Appoints chairman although terms are not concurrent

Should the Fed Be Independent?

The Case for Independence

The strongest argument for an independent central bank rests on the view that subjecting it to more political pressures would impart an inflationary bias to monetary policy.

The Case Against Independence

Proponents of a Fed under the control of the president or Congress argue that it is undemocratic to have monetary policy (which affects almost everyone in the economy) controlled by an elite group that is responsible to no one.

The Case For Independence

Political pressure would impart an inflationary bias to monetary policy

Political business cycle

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

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

The Case Against Independence

Undemocratic

Unaccountable

Difficult to coordinate fiscal and monetary policy

Has not used its independence successfully

Explaining Central Bank Behavior (1 of 2)

One view of government bureaucratic behavior is that bureaucracies serve the public interest (this is the public interest view). Yet some economists have developed a theory of bureaucratic behavior that suggests other factors that influence how bureaucracies operate.

The theory of bureaucratic behavior may be a useful guide to predicting what motivates the Fed and other central banks.

Explaining Central Bank Behavior (2 of 2)

Theory of bureaucratic behavior: objective is to maximize its own welfare which is related to power and prestige

Fight vigorously to preserve autonomy

Avoid conflict with more powerful groups

Does not rule out altruism

Inside the Fed: The Evolution of the Fed’s Communication Strategy

The Fed has dramatically increased its transparency in recent years

Following the January, April, June and November FOMC meetings, the Chair of the Board of Governors holds a press conference to clarify monetary policy communications.

Greater transparency has been provided with the announcement of a specific numerical target for the inflation rate.

Structure and Independence of the European Central Bank

Patterned after the Federal Reserve

Central banks from each country play similar role as Fed banks

Executive Board:

President, vice-president and four other members

Eight year, nonrenewable terms

Governing Council

Differences Between the European System of Central Banks and the Federal Reserve System

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

Monetary operations are not centralized

Does not supervise and regulate financial institutions

Governing Council

Monthly meetings at ECB in Frankfurt, Germany

Nineteen National Central Bank heads and six Executive Board members

Operates by consensus

ECB announces the target rate and takes questions from the media

To stay at a manageable size as new countries join, the Governing Council will be on a system of rotation.

How Independent Is the ECB?

Most independent in the world

Members of the Executive Board have long terms

Determines own budget

Less goal independent

Price stability

Charter cannot by changed by legislation; only by revision of the Maastricht Treaty

Structure and Independence of Other Foreign Central Banks

Bank of Canada

Essentially controls monetary policy

Bank of England

Has some instrument independence.

Bank of Japan

Recently (1998) gained more independence

The trend toward greater independence