Unit 3 Lecture 1 – EC311 Susanto
CENTRAL BANKS AND THE FEDERAL
RESERVE SYSTEM
The Price Stability Goal
• Low and stable inflation
• Inflation:
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Increase in overall price levels
Creates uncertainty and difficulty in planning for the future
Lowers economic growth
Strains social fabric
• Nominal anchor to contain inflation expectations
– Ties down price levels within a narrow range to promote
price stability
• Time-inconsistency problem
– Tendency towards pursuing expansionary economic policy
to boost the economy  This raise inflation expectations
 Drives wages and prices up [No real output growth]
Other Goals of Monetary Policy
• High employment
– Can’t attain zero unemployment, but the goal is to have the “natural
rate of unemployment” only
• Economic growth
– Related to high employment
– Supply side economics: promote growth by encouraging firms to invest
and people to save
• Stability of financial markets
• Interest-rate stability
– Fluctuations make it harder for consumers and businesses to plan for
the future  affect willingness to buy
• Foreign exchange market stability
– Dollar up too much: American industries less competitive
– Dollar down too much: stimulate inflation in the U.S.
Should Price Stability be the Primary Goal?
• In the long run there is no conflict between the goals
• In the short run, it can conflict with the goals of high
employment and interest-rate stability
• Hierarchical mandate
– Price stability goal comes first, the rest are secondary
• Dual mandate
– Achieve two co-equal objectives: price stability and
maximum employment
• Price stability should be the primary, long-run goal,
while reducing business cycle fluctuation should be
the secondary, short-term goal
Functions of a central bank
2 sets of functions:
A. Macro functions
1. Issue money (Fed issues US notes)
2. Provide lender of last resort function
3. Undertake monetary policy
4. Manage reserves of commercial banks (the
banker’s bank function)
5. Advise the federal government and manage the
government’s finances
Functions of a central bank
B. Micro functions
1. Regulate the financial system
2. Supervise certain types of banks
3. Provide check clearing service
All central banks have functions listed under A. Some
central banks have functions listed under B, some
do not.
Origins of the Federal Reserve System
• Created by the Federal Reserve Act of 1913
– Goal: maintain same sort of decentralized power and
system of checks and balances.
• In practice:
– Division of power between the Board of Governors in
Washington and the Federal Reserve Banks in 12 cities.
– Division of power between the Federal Government, the
banking industry, non-bank business interests.
• Consequence: Separate but important roles
Structure of the Fed
Fed consists of 2 parts:
• Regional Feds – split into 12 district banks; each is owned by
local commercial banks
• Fed HQ in DC – consists of Board of Governors and FOMC, and
also comprises research functions.
– The largest Federal Reserve Banks in terms of assets are: New York
(2nd district), Chicago (7th district), and San Francisco (12th district).
– The Federal Reserve Bank of New York is the largest and most
important, reflecting the role of New York as the financial center of
the US and the world.
– The Federal Reserve Bank of Boston is headquarters for the 1st
district.
Monetary policy
Monetary policy tools are:
• Reserve requirements: requiring banks to keep a certain
% of deposits as reserves  least frequently used
• Discount rate changes: rate that banks pay for
borrowing from the Fed.
• Open market operations: buying and selling of
government debt to expand or contract money supply
 most commonly used.
Formal
Structure of
the Fed
Board of Governors
• Seven members headquartered in Washington, D.C.
• Appointed by the president and confirmed by the
Senate.
• Each serves a 14-year non-renewable term.
• Required to come from different districts.
• Chairman is chosen from the governors and serves a
four-year term.
Duties of the Board of Governors
• Votes on conduct of open market operations
• Sets reserve requirements
• Controls the discount rate through “review and
determination” process
• Sets salaries of president and officers of each Federal Reserve
Bank and reviews each bank’s budget
• 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 Reserve Districts
Fed district banks
• Each Federal Reserve Bank is a legally separate
corporation that is owned by the commercial banks in
its district.
• Quasi-public institution.
• Member banks elect six directors for each district;
three more are appointed by the Board of Governors
– 3 Class A Directors = bankers, elected by member banks.
– 3 Class B Directors = other business leaders in industry,
commerce, and agriculture, also elected by member banks.
– 3 Class C Directors = representatives of the non-bank
public, appointed by the Board of Governors.
Functions of the Federal Reserve District Banks
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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
Act as liaisons to the business community
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 District Banks and Monetary Policy
• Directors “establish” the discount rate
– The directors of each bank recommend a setting for the discount rate,
which is then approved by the Board of Governors.
• 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)
– The New York Fed runs the Open Market Desk, where open market
operations are conducted at the request of the FOMC
Member commercial banks
• All national banks are required to be members
– Commercial banks chartered by states are not required but may
choose to be members
• Before 1980, only member banks were required to hold
reserves as vault cash or deposits at Fed Banks.
– These reserves do not pay interest. Many states allowed nonmember
banks to hold reserves in the form of interest-earning securities. As a
result, many state banks chose not to become members and, as
interest rates rose during the 1970s, many state banks who were
members decided to leave the Federal Reserve System.
• 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.
Informal
Structure of
the Fed
Monetary policy in practice
• Monetary policy effectively determined by the FOMC at its
meetings every 6 weeks (or sooner)
• They determine Open market operations and usually determine
the level of the discount rate too
• Chairman of the Fed also testifies to Congress and the Senate
on a regular basis
• Chairman advises the U.S. President on economic policy
• Fed is not completely independent of government – can be
influenced by the White House to a degree.
Federal Open Market Committee
• The Federal Open Market Committee (FOMC) meets
eight times per year.
• The FOMC consists of:
– All 7 members of the Board of Governors.
– The president of the New York Fed and four other Reserve
Bank presidents.
• The seven Reserve Bank non-voting presidents are not
on the FOMC, but they still attend the meetings and
participate in the discussions.
– The Governors as a group have 7 of the 12 votes–and hence
a majority of the votes on FOMC
FOMC’s roles
• The FOMC’s principal role is to make decisions regarding the
conduct of open market operations.
• Thus, the FOMC controls the monetary base, and thereby exerts
the most powerful influence on the money supply as a whole.
• Within the Federal Reserve System, the FOMC plays the most
important role in formulating monetary policy.
• Three key documents are prepared before each FOMC meeting:
– Green Book = Contains forecasts for the US economy
– Blue Book = Contains an outline of different monetary policy options
– Beige Book = Contains a description of economic activity within each of
the 12 Federal Reserve districts.
• Only the beige book is released to the public.
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
Central Bank Independence
Factors making Fed independent
1. Members of Board have long terms
2. Fed is financially independent: This is most important –
only Fed can run the printing presses and it gives
government its profits at the end of the year.
Factors making Fed dependent
1. Congress can amend Fed legislation
2. President appoints Chairmen and Board members and can
influence legislation
Overall: Fed is relatively independent compared with other
central banks around the world.
Explaining Central Bank behavior
Theory of bureaucratic behavior: bureaucracy’s objective is to
maximize its political influence and its member’s welfare
1. Is an example of principal-agent problem: principals are
the voters, agents are the bureaucracies
2. Bureaucracy often acts in own interest – not in the
country’s
Implications for Central Banks:
1. Act to preserve independence
2. Try to avoid controversy: often plays games
3. Seek additional power over banks
Independence: the case for and against
Should Fed be Independent?
Case For:
1. Independent Fed likely has longer-run objectives,
politicians don't: evidence is better policy outcomes
2. Avoids political business cycle
3. Less likely deficits will be inflationary
Case Against:
1. Fed may not be accountable to public
2. Hinders coordination of monetary and fiscal policy
3. Fed has often performed badly – e.g. Great Depression