Central Banks and the

Federal Reserve System

Chapter 16
 Origins of the Federal
Reserve System
• Resistance to establishment of a central bank
o Fear of centralized power
o Distrust of moneyed interests
• No lender of last resort
o Nationwide bank panics on a regular basis
o Panic of 1907 so severe that the public was
convinced a central bank was needed
• Federal Reserve Act of 1913
o Elaborate system of checks and balances
o Decentralized
 Structure of the Federal
Reserve System
• 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
 Federal Reserve Banks
• Member banks elect six directors for each
district; three more are appointed by the Board
of Governors
o Three A directors are professional bankers
o Three B directors are prominent leaders from
industry, labor, agriculture, or consumer
sector
o Three C directors appointed by the Board of
Governors
are not allowed to be officers, employees, or
stockholders
of banks
 Functions of the Federal
Reserve Banks
• 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 (cont’d)
• 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
 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
• 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 (cont’d)
• 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
 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
o Influence on Congress
o Appoints members
o Appoints chairman although terms are not
concurrent
 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
• 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
 Explaining Central Bank
Behavior (cont’d)
• Theory of bureaucratic behavior:
objective is to maximize its own welfare
which is related to power and prestige
o Fight vigorously to preserve autonomy
o Avoid conflict with more powerful
groups
• Does not rule out altruism
 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
o President, vice-president and four other
members
o Eight year, nonrenewable terms
• Governing Council
 Differences Between the ECB
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
 How Independent Is the
ECB?
• Most independent in the world
• Members of the Executive Board have long
terms
• Determines own budget
• Less goal independent
o Price stability
• Charter cannot by changed by legislation;
only by revision of the Maastricht Treaty