14 – Central Banks
Cecchetti Chapter 15
Early History of the Fed

Federal Reserve Act: 1914

Created as a bureau of the Treasury and the
Secretary of Treasury was required to serve as
an ex officio Chairman of the Federal Reserve
Board.

Act signed by President Wilson
Central Banks

Primary reason central banks exist: print
currency and control monetary policy
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Free markets cannot do this: adverse selection
Banker’s Bank
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Provide loans during times of financial stress
Manage the payments system
Regulate commercial banks
How does the Fed Work?

When the Fed wishes to increase the money supply
(shift AD curve to right)
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When the Fed wishes to decrease the money supply
(shift AD curve to left)
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Buys U.S. bonds from commercial banks
Sells U.S. bonds from commercial banks
Together these are called “open market operations”
Money Supply and Interest
Rates

When the money supply increases,
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interest rates drop
inflation pressure increases
When the money supply decreases,
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interest rates increase
Inflation pressure decreases
Central Bank Objectives

Low stable inflation

High Stable Real Growth

Stability of the financial system
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Interest Rate Stability
Effective Central Banks

Independence from political pressure
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Decision making by committee
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Control over own budgets
Policies must be irreversible
Risk of putting one person in charge can be high
Accountability and Transparency

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Establish a system of goals
Publicly report progress
Independent Central Banks
Do independent central banks just keep
the money supply too low (line A)?
P
Do central banks run by political leaders
do a better job keeping the economy
Running at full capacity (line B)?
B
A
Aggregate Output, Y
Independent Central Banks
Empirical Evidence:
B
There is no difference in unemployment
rates across countries with independent
central banks (line A) and without
Independent central banks (line B).
P
A
Countries without independent central banks
Just have higher inflation.
Aggregate Output, Y
Banking Act of 1935

Federal Reserve reorganized
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Board of Governors shall be composed of seven
members, appointed by President
Among these is appointed a Chairman and Vice
Chairman
First Chairman: Mariner S. Eccles


A principal sponsor of the act
Was serving as an assistant to the Secretary of the
Treasury and a Governor of the Federal Reserve
Board
Mariner S. Eccles
Fed Chairman 1936 – 1948
Fed Governor 1948-1951
Federal Reserve Eccles
Building
Eccles and Fed independence

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1947: Inflation at 14%
1948: Inflation at 8%
Treasury wanted to keep rates low
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Facilitate war debt funding
Fed (Eccles) wanted to contain inflation
Congress supported Eccles
Truman declines to reappoint Eccles in 1948
Eccles and Fed Independence

Thomas McCabe Chairman 1948-1951
1951: Same argument between
Treasury and Fed emerged

Truman calls FOMC to Whitehouse


Snyder, Secretary of Treasury,
announces that rates will be kept at 2.5%
Eccles and Fed Independence

Eccles releases confidential minutes of
White House meeting to public

Asks Truman to resolve the conflict
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Truman had William McChesney
Martin, a Treasury Official, negotiate.
Eccles and Fed Independence

Martin made the Chair of the Fed in 1951.

Accord of 1951 was signed making clear
that the Fed was independent of the
Treasury.
Federal Reserve System

Central Government Agencies
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Board of Governors
12 regional banks
FOMC

Private Banks
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Advisory Committees
Federal Reserve Regional
Banks
Board of Governors
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Seven Governors
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Chairman and Vice Chairman
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
Appointed by President
Confirmed by Senate
Serve 14 –year terms
Terms staggered with a term beginning once every two years
Appointed by president from among the seven
Four year terms
No two governors can serve from the same district
Board of Governors Duties

Analyzes financial and economic conditions

Administers consumer credit protection laws
Supervises and regulates the regional Reserve
Banks, including budgets and salaries
Sets the reserve requirement
Approves bank merger applications
Regulates and supervises the banking system
Collects and publishes data
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Regional Banks
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Federally charted banks and private, nonprofit
organizations owned by commercial banks
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Managed in part by Board of Directors
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Nine members
Some chosen by private banks
Others chosen by Board of Governors
Managed in part by a president

Appointed for a five-year term by banks board of
directors with approval from Board of Governors
Regional Banks
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As the bank for U.S. government
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Issue new currency and destroy old currency
Maintain U.S treasury bank account/borrowings
As the banker’s bank
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Hold deposits (reserves) which pay zero interest
Operate payments network (checks, debit cards, . . .)
Make discount loans
Supervise and regulate financial institutions
Collect data
Federal Reserve Bank of New
York

Point of contact with financial markets
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Open market operations
Treasury securities are auctioned
Federal Open Market
Committee

Has twelve voting members

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Seven governors
President of FRB New York
Four Reserve Bank Presidents

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Serve one-year terms
President of FRB Chicago and Cleveland vote
every other year
Other nine presidents vote one out of every three
years
Federal Funds Rate

Federal Funds Rate

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

Rate at which banks borrow from each
other overnight
Determined by supply and demand
When there are excess reserves, FF rate
is low
When there is low supply of reserves, FF
rate is high
Discount Rate

Rate at which banks can borrow
money from Fed at discount window.

Set by regional banks’ boards of
directors

Set automatically at a premium above the
Federal Funds rate.
FOMC

Targets Federal Funds Rate


If prices are “sticky” than they influence
the “real rate”
Real = Nominal – Inflation
Policy decision directs staff at FRB
New York to engage in open market
operations
Federal Open Market
Committee

Beige Book
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Green Book
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Published two weeks before meeting
Anecdotal information about economic conditions
Only document released to public before meeting
Distributed Thursday before meeting
Board Staff’s economic forecast for next few years
Blue Book
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Distributed Saturday before meeting
Discussion of current markets and policy options
Power Within the FOMC

Governors make up a majority

Green and Blue books prepared by Fed staff

Before formal vote, chair makes recommendation followed by others
saying “yes” or “no”

All bank presidents participate

Chair votes first

Board controls Regional Bank budgets and salaries

To impact policy, governors and bank presidents must generate
support through statements in meeting and in public.
Assessment of Fed Structure

Independence
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Control own budget
Decisions can’t be over-turned
Terms are long
Structure can only be changed by
congressional legislation
Decision by committee
Assessment of Fed Structure

Accountability and transparency
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Load of information on web sites
Immediately after meeting: announcement of policy decision
and explanatory statement
Minutes published about two weeks later
After 5-years: word-for-word transcript, Blue and Green Books
Twice yearly “Monetary Report to Congress” (see next slide)
Is it the right information?
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No press conference
Blackout period
5-year delay for transcript, Green and Blue Books
Inflation Targets?
Press Release 11/14/2007

The Federal Open Market Committee
(FOMC) announced on Wednesday that, as
part of its ongoing commitment to improve
the accountability and public understanding
of monetary policy making, it will increase
the frequency and expand the content of the
economic projections that are made by
Federal Reserve Board members and
Reserve Bank presidents and released to
the public.
Press Release 11/14/2007

The FOMC will
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compile and release projections four times each
year rather than twice a year.
The projection horizon will be extended to three
years, from two.
FOMC meeting participants will now provide
projections for

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inflation
real gross domestic product growth,
the unemployment rate
core inflation.