Chapter 16 - The Structure of Central Banks: The Federal Reserve and the European Central Bank

Chapter 16
The Structure of Central Banks:
The Federal Reserve and the European Central Bank
Chapter Overview

In this chapter we examine two important central banks, the U.S. Federal Reserve System
and the European Central Bank, and see how their structure helps them to meet their
objectives.

Reading this chapter will prepare students to:

• Understand the structure of the U.S. central bank, the Federal Reserve System;
• Explain the structure of the FOMC and articulate its important role in conducting
monetary policy;
• Understand the structure of the European Central Bank and compare it to that of
the Fed;
• Assess the criteria used in judging the success of modern central banks.

Important Points of the Chapter

The instability and chaos that accompany financial panics damage more than just the
banks that are directly involved; everyone is slow to regain confidence in the financial
system after a panic, making it hard for anyone to obtain financing. The more frequent
the panics the worse the situation gets, and the slower the economy grows. The
punishing effects of frequent financial panics led people to reconsider the merits of a
powerful central bank. For Europe in the 20th century, however, central banking was not
enough, and leaders came to believe that the only way to ensure both political and
economic stability was to forge closer ties among the continent’s countries. This led to
the European monetary union, with its common currency (the euro) and its central bank
(the European Central Bank, or ECB).

Application of Core Principles

Principle #5: Stability. The Board of Directors of each Federal Reserve Bank is made up
of bankers but also of business leaders and others that represent the public interest.
Though the range of views represented is wide, everyone has an interest in ensuring
economic and financial stability.

Principle #3: Information. The FOMC releases huge amounts of information to the
public, but lots of information isn’t always the right information. There is no regular
press conference or questioning of the Chair on the FOMC’s current policy stance and
some information is released at varying amounts of time after the meeting.

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Principle #5: Stability. Fed officials state that they strive to attain “price stability and
maximum sustainable economic growth” but do not specify what is meant by either term.

Principle #3: Information. Like the Federal Reserve, the ECB distributes large volumes
of information, both on paper and on its website, but the most important aspect of the
ECB’s communication strategy concerns statements about the Governing Council’s
policy deliberations. Unlike the FOMC there is a press conference and transcripts are
made immediately available.

Principle #5: Stability. The Treaty of Maastricht states that the primary objective of the
ECB is to maintain price stability. As with the Fed’s legislatively dictated objectives, the
statement is vague.

Teaching Tips/Student Stumbling Blocks

• If you have the equipment to do so, you can put some names and faces to the
text’s references to the FOMC. Visit its web site at
http://www.federalreserve.gov/FOMC/ and scroll down to the bottom of the page.
You’ll find a listing of the members and links to their photos and bios.

• You may find members of the European Central Bank’s Governing Council at
http://www.ecb.int/ecb/orga/decisions/govc/html/index.en.html.

Features in this Chapter

Your Financial World: Treasury Direct

Treasury Direct lets you buy as little as $1,000 worth of Treasury securities without
paying any broker fees; all you need to do is fill out a few forms, write a check, and send
them in. And that’s only for the first time; afterwards you can make purchases
electronically. Since the securities are sold by bid, purchasers place a noncompetitive
bid, which means that they will receive the bond they want at the average auction price.

Tools of the Trade: Decoding the FOMC Statement

Following every meeting, the FOMC issues a press release announcing its policy
decision. As the financial crisis deepened in 2008, the form of the statement changed
markedly. A typical statement continues to include the current target for the federal
funds rate, provides a brief synopsis of the Committee’s views of current conditions, and
a report of the vote. The statement tells us about the current state of the economy and
indicates what the FOMC’s near term policy actions will likely be, and indicating what
will trigger the next move. The statement also includes a description of the policy tools
that the Fed will use to achieve its objectives.

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Applying the Concept: The Evolution of Federal Reserve Independence

In 1935, the Secretary of the Treasury and the Comptroller of the Currency were removed
from the Federal Reserve Board and the FOMC was created. The Fed lost some of its
independence during World War II, when maintaining low interest rates for the war effort
become a priority, but this was regained in the 1950s. Of course, the FOMC’s ability to
do its job still depends on the willingness of politicians to refrain from interference.
Fortunately, in recent years, politicians have been supportive of the Fed, both its day-to-
day policies and its institutional structure.

Your Financial World: The Fed Can't Save You from a Stock Market Crash

In the late 1990s many investors came to believe that the Fed would not let the stock
market decline significantly because such a decline would reduce spending, sending the
economy into a recession. As a result, stocks were perceived as being less risky, and the
risk premium became smaller, driving prices up even further. But the Fed doesn’t control
the stock market, and the market did decline in 2001 and 2002. No one can eliminate the
risk that is inherent in an investment—not even the most powerful central bank in the
world.

In the News: Fed Adopts De Facto Inflation Target

The US Federal reserve adopted a de facto inflation target of two percent early in 2009.
This target mirrors the formal target set by the European Central Bank. Officials had
recently changed forecasts on inflation and forecasted a contraction in GDP and an
increase in unemployment. The forecasted inflation was to be interpreted as a target, but
not a formal target, according to Fed Chairman Ben Bernanke.

Lessons of the Article: As an economics professor at Princeton University, Ben

Bernanke wrote about the virtues of central banks adopting inflation targets. But the
adoption of a new policy framework depends on building political support both
among members of the FOMC and in the U.S. Congress, which oversees the Fed.
Under chairman Bernanke, the FOMC gradually adjusted its procedures to become
more like those of an inflation-targeting central bank, but there remained important
differences. Has the FOMC announced an explicit inflation target?

Lessons from the Crisis: Government Funding in the Euro Area

The designers of the European Central Bank wanted to be sure that it would never
sacrifice price stability to finance a fiscal deficit by introducing a no-bail-out clause in the
Maastricht Treaty that forbids the ECB from directly helping a government facing
financial distress. After the financial crisis of 2007-2009, the rule came close to a test. In
early 2010, investor worries of large fiscal deficits led to a large widening of yield
spreads, indicating default risk posed a threat to funding liquidity. If some euro area

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countries became unable to borrow, the fall-out would spread across the region. So what
could they do? One approach would be to have other euro countries loan to the distressed
countries. Another would be to guarantee debt issues.

Additional Teaching Tools

In a speech, found at http://www.ecb.int/press/key/date/2010/html/sp100618.en.html

entitled “Central Banks and Development of the World Economy: New Challenges and a
Look Ahead” given at the 150th Anniversary of the Central Bank of the Russian
Federation High-Level International Conference, Moscow,18 June 2010, Jean-Claude
Trichet, President of the ECB discusses the lessons learned in the financial crisis of 2007-
2009.

Virtual Tools

Visit the Federal Reserve on the web at:

http://www.federalreserve.gov

Visit the European Central Bank on the web at:

http://www.ecb.int/home/html/index.en.html

Visit the Bank of England on the web at:

http://www.bankofengland.co.uk/Links/setframe.html

For More Discussion

We can turn on C-SPAN (assuming we have cable!) and watch Congress debate
important issues that will affect our lives. But the FOMC meets in secret, making
decisions that are arguably critical to our financial lives. Is the FOMC fundamentally
undemocratic? Should its operations be changed?

Chapter Outline

I. The Structure of the Federal Reserve System

1. The Federal Reserve Act, passed in 1913 and amended several times since
then, establishes a system that is composed of three branches with overlapping
responsibilities.
2. There is are the twelve regional Federal Reserve Banks, distributed
throughout the country; a central governmental agency, the Board of
Governors, located in Washington, D.C.; and the Federal Open Market
Committee.

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3. In addition, a series of advisory committees makes recommendations to the

Board and the regional Banks.
4. Finally, there are the commercial banks that are members of the system.
5. This complex structure diffuses power in a way that is typical of the U.S.
government, creating a system of checks and balances that reduces the
tendency for power to concentrate at the center.
6. All national banks (chartered by the federal government) are required to
belong to the Federal Reserve System, and state banks have the option to join
(though less than 20 percent do because of the cost involved).
7. Members and nonmembers alike must hold non-interest bearing reserve
deposits at the Fed, so there is no real distinction between them.
A. The Federal Reserve Banks
1. The Federal Reserve Bank of New York is the largest of the twelve regional
Federal Reserve Banks.
2. The geographical lines that define the Banks’ districts were drawn in 1914 and
represent the population density at the time and the decision that no district
should coincide with a single state.
3. This arrangement has two purposes: to ensure that every district contains as
broad a mixture of economic interests as possible and that no person or group
can obtain preferential treatment from the Reserve Bank.
4. Reserve Banks are part public and part private; they are owned by the
commercial banks in their districts and are overseen by the Board of
Governors.
5. The Board of Directors of each bank is comprised of representatives of
banking, other business leaders, and those who represent the public interest.
Of the nine members on each board, six are elected by the commercial bank
members and three are appointed by the Board of Governors.
6. Each Reserve Bank has a President who is appointed for a five-year term by
the Bank’s Board of Directors (with the approval of the Board of Governors).
7. The Reserve Banks conduct the day-to-day business of the central bank,
serving as both the government’s bank and the bankers’ bank.
8. As the bank for the U.S. government they issue new currency, maintain the
U.S. Treasury’s bank account, and manage the U.S. Treasury’s borrowings.
9. As the bankers’ bank they hold deposits for the banks in their districts, operate
and ensure the integrity of a payments network, make funds available to
commercial banks in the district through “discount loans,” supervise and
regulate financial institutions in the district, and collect and make data
available on business conditions.

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10. In addition to these duties the Federal Reserve Bank of New York provides
services to foreign central banks and to certain international organizations that
hold accounts there; it is also the System’s point of contact with financial
markets.
11. Finally, the Reserve Banks play an important part in formulating monetary
policy, both through their responsibilities on the FOMC and through their
participation in setting the discount rate.
B. The Board of Governors
1. The seven members of the Board are appointed by the President and
confirmed by the U.S. Senate for 14-year terms, which are staggered
(typically one new member is appointed every two years).
2. These long terms are intended to protect the Board from political pressure, as
is the fact that the terms are staggered so that one begins every two years.
3. The Board has a Chairman and a Vice Chairman, appointed by the President
from among the seven governors for four-year renewable terms.
4. The duties of the Board are to: set the reserve requirement, approve or
disapprove the discount rate recommendations made by the Federal Reserve
Banks, administer consumer credit protection laws, approve bank mergers,
supervise and regulate the regional Reserve Banks, regulate and supervise the
banking system (along with the Reserve Banks), analyze financial and
economic conditions, and collect and publish statistics about the system’s
activities and the economy at large.
C. The Federal Open Market Committee
1. The FOMC is the group that sets interest rates to control the availability of
money and credit to the economy.
2. Made up of the seven Governors, the President of the NY Fed, and four
Reserve Bank Presidents, it is chaired by the Chairman of the Board of
Governors.
3. The FOMC controls the federal funds rate, the rate banks charge each other on
overnight loans of excess deposits at the Fed.
4. The FOMC meets eight times a year, although in extraordinary times it can
meet more often.
5. The primary purpose of a meeting is to decide on the target interest rate and
produce a policy directive, which tells the NY Fed how to conduct purchases
and sales of Treasury securities in order to meet the FOMC’s goals.
6. Prior to each meeting participants receive the beige book (a compilation of
anecdotal information about current business activity), the green book (the

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Board staff’s economic forecast for the next few years) and the blue book (a
discussion of financial markets and current policy options).
7. An FOMC meeting is a formal proceeding that can be divided into three parts:
reports by the staff, and two rounds of discussion by the meeting participants.
8. Reports by the staff include presentations by the System Open Market
Account Manager (reporting on financial market conditions and actions taken
to maintain the target interest rate since the last meeting); the Director of the
Division of International Finance (commenting on recent international
economic developments); and the Director of the Division of Research and
Statistics at the Federal Reserve Board (presenting the staff’s forecast from
the green book).
9. The ensuing round of discussion is called the economic go-round. One at a
time committee members describe their view of the economic outlook, and
then the Chair speaks at the end.
10. Next, the Director of Monetary Affairs describes the policy options (from the
blue book). Committee members again comment on the options, with the
Chair speaking last.
11. Finally there is a vote taken, with the Chair voting first, the Vice Chair
second, and then the committee members (in alphabetical order).
12. The Chair of the Federal Reserve is the FOMC’s most powerful member; to
have an impact on policy, governors or Reserve Bank presidents must build
support for their positions through their statements at the meeting and in
public speeches.
13. However, while the Chair is very powerful, the committee structure does
provide an important check on that person’s power.
II. Assessing the Federal Reserve System’s Structure
A. Independence from Political Influence
1. The Fed controls its own budget, which is an important criterion for central
bank independence.
2. The Fed does occasionally come under political attack, especially when it
believes it must raise interest rates.
B. Decision Making by Committee
1. The Fed meets this criterion for independence because the FOMC is a
committee.
2. The chair may dominate policy decisions, but the fact that there are 12 voting
members provides an important safeguard against arbitrary action by a single
individual.

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C. Accountability and Transparency

1. The FOMC releases huge amounts of information to the public.
2. However, there is no regular press conference or real questioning of the chair
on the FOMC’s current policy stance.
3. Moreover, some information is released well after the fact of the meeting.
4. Also, the Committee’s refusal to state its objectives clearly and concisely
hampers communication.
D. Policy Framework
1. The Congress of the United States has set the Fed’s objectives, but the
statement is vague enough that the Fed can essentially set its own goals.
2. Many people have argued that the system should be replaced by one in which
the FOMC’s objectives are made clear and the Committee announce a specific
numerical objective for consumer price inflation over some horizon.
III. The European Central Bank
A. Organizational Structure
1. The Eurosystem mirrors the structure of the Federal Reserve in that there is an
Executive Board (like the Board of Governors), the National Central Banks
(like the regional Federal Reserve Banks) and the Governing Council (which,
like the FOMC, formulates monetary policy).
2. The Executive Board has a President and Vice President who play the same
role as the Chairman and Vice Chairman of the Fed.
3. The ECB and the NCBs together perform the traditional operational functions
of a central bank; they use interest rates to control the availability of money
and credit in the economy, are responsible for the smooth operation of the
payments system, and issue currency.
4. The NCBs continue to serve as bankers to the banks and governments in their
countries.
5. Unlike the Fed, the ECB does not supervise and regulate financial institutions.
Also, the implementation of monetary policy is not centralized and the ECB’s
budget is controlled by the NCBs and not vice versa.
6. The focus of the ECB’s activity is on the control of money and credit in the
Eurosystem.
7. The Governing Council meets monthly and decisions are made by consensus;
no formal votes are taken, because votes may get in the way of good policy.
8. The ECB’s independence is protected by long terms of office, the fact that the
ECB’s financial interest must remain separate from any policy organization,

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and by the provision in the Treaty of Masstricht that the Governing Council
cannot take instructions from any government.
9. As the number of members in the Eurosystem has increased, the Governing
Council has adopted a rotating system for voting like that used by the FOMC.
B. Accountability and Transparency
1. The most important aspect of the ECB’s communication strategy concerns
statements about the Governing Council’s policy deliberations; unlike the
FOMC there is a news conference at which questions are taken and the
transcript is posted on the website immediately.
2. The primary problem with ECB communications is that there often are a
number of conflicting opinions expressed.
3. But indications are that the system is working and that there is accountability.
C. The Price Stability Objective and Monetary Policy Strategy
1. The Treaty of Maastricht states that the primary objective of the ECB is to
maintain price stability.
2. The ECB’s strategy has been to numerically define price stability and to focus
on a broad-based assessment of the outlook for future prices, with money
playing a prominent role.
3. Price stability is defined as inflation of close to 2 percent, based on a euro-
area wide measure of consumer prices called the Harmonized Index of
Consumer Prices (similar to the U.S. CPI).
4. The economically large countries matter much more than the small ones,
which affects the dynamics of the Governing Council’s policy making.
5. However, evidence suggests that the ECB is doing the job it is supposed to do.

Terms Introduced in Chapter 16

Board of Governors of the Federal Reserve System

discount rate
emergency powers
euro area
European Central Bank (ECB)
European System of Central Banks (ESCB)
Eurosystem
Executive Board of the ECB
federal funds rate
Federal Open Market Committee (FOMC)
Federal Reserve Banks
Federal Reserve System
FOMC Statement

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Governing Council of the ECB

National Central Banks (NCBs)

Lessons of Chapter 16

1. The Federal Reserve System is the central bank of the United States. Its
decentralized structure comprises three primary elements:
a. Twelve Federal Reserve Banks, each with its own Board of Directors,
that:
i. Serve as the government's bank, issuing currency, maintaining the
U.S. Treasury’s bank account, and handling the Treasury’s securities.
ii. Serve as the bankers’ bank, holding deposits, operating a payments
system, making loans, and evaluating the safety and soundness of
financial institutions in their districts.
b. The seven-member Board of Governors in Washington, D.C., including
the chair
i. Regulates and supervises the financial system.
ii. Oversees the Federal Reserve Banks.
iii. Publishes economic data.
c. The Federal Open Market Committee
i. Makes monetary policy by setting interest rates.
ii. Has 12 voting members, including the 7 Governors and 5 of the 12
Reserve Bank Presidents.
iii. Meets 8 times a year.
iv. Is controlled largely by the chair.

2. The FOMC's success in meeting its objectives is enhanced by

a. Its independence, which comes from its members’ long
terms, budgetary autonomy, and the irreversibility of its policy decisions.
b. Clear communication of its policy decisions through an
explanatory statement that is distributed immediately and minutes that are
published following the next meeting.
c. Regular public appearances of the committee's members.

3. It is impaired by
a. Its unwillingness to define exactly what is meant by the stated goals of price
stability and sustainable economic growth.
b. Its unwillingness to respond to questions about its policy stance in a timely
manner.

4. The European Central Bank (ECB) is the central bank for the countries that
participate in the European monetary union.
a. The ECB is composed of three distinct parts:
i. The National Central Banks (NCBs) provide services to the banks and
governments in their countries.

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ii. The European Central Bank in Frankfurt, with its six-member Executive
Board, which oversees the monetary system.
iii. The Governing Council, which makes monetary policy decisions.
b. The ECB’s primary objective is to stabilize prices in the common currency
area.
c. The ECB’s success in meeting its policy objectives is aided by the timely
announcement of policy decisions, press conferences in which top ECB
officials respond to questions, and the release of twice-yearly forecasts.
d. The ECB’s success is impaired by the fact that the minutes of its policy
meetings are not published for 20 years.

Conceptual Problems

1. What are the Federal Reserve’s goals? How are Fed officials held accountable for
meeting them?

Answer: The goals of the Federal Reserve, as set by Congress are to “maintain
long run growth of the monetary and credit aggregates commensurate with the
economy's long run potential to increase production, so as to promote effectively
the goals of maximum employment, stable prices, and moderate long-term interest
rates." The Fed’s officials release large amounts of information in order to
maintain accountability. After each of the meetings of the FOMC, the target
interest rate is released immediately, along with a brief statement. Minutes and
transcripts of the meetings are also eventually made public. Members of the
FOMC give public speeches and the chair reports to Congress and twice a year.

2. Go to the Federal Reserve Board's Web site and locate the FOMC’s most recent
statement. What did the committee members say at their last meeting regarding
the Federal funds target and the two goals of price stability and sustainable
economic growth? Does the statement make any reference to the financial
stability goal?

Answer: At the March 16, 2010 meeting, the FOMC kept the target federal funds
rate at 0-1/4 percent. The Committee wrote that economic activity continued to
strengthen but that unemployment remained high and there was considerable
resource slack. In light of that, inflation was likely to remain subdued for some
time and conditions were likely to warrant exceptionally low levels of the federal
funds rate for a considerable period. The statement mentioned that the Fed had
been closing the special liquidity facilities it had created during the crisis and that
the last remaining program would close over the next few months.

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3. Some people have argued that the high inflation of the late 1970s was a
consequence of the fact that Federal Reserve Board Chairman Arthur Burns did
what President Richard Nixon wanted him to do. Explain the connection.

Answer: Because politicians are elected for relatively short terms, they favor
expansionary monetary policy that will boost growth in the short run. However,
this will eventually lead to higher inflation. This is why it is important for the
central bank to be independent.

4. How might the financial crisis of 2007-2009 lead to a change in appointment

process of presidents of the regional Federal Reserve banks?

Answer: The bailouts of financial institutions during the crisis fueled a public
perception that the reserve banks are too sympathetic to the private banks, in part
because presidents of regional Feds are often from the ranks of private bankers.
Public outcry may result is a change in the appointment process.

5. *How did the political climate in the early 1900’s influence the structure of the
Federal Reserve System?

Answer: The reluctance to centralize power is evident in the complex structure of

the Federal Reserve System. The combination of the Board of Governors in
Washington D.C. and the Federal Reserve Banks serving various districts diffuses
power away from the center and creates a system of checks and balances.

6. While the Chair of the Federal Reserve Board has only one of 12 votes on the
FOMC, he is never in the minority. What gives him the power to control the
committee?

Answer: The Chair controls the staff of the Board of Governors that produces the
material distributed to the Committee members prior to the meeting; he controls
the agenda of the meeting; he controls when people speak; and he is the first to
make a policy recommendation.

7. What are the goals of the ECB? How are its officials held accountable for meeting
them?

Answer: The primary goal of the ECB is to maintain price stability, which the
ECB defines as inflation of less than, but close to, two percent using the
Harmonized Index of Consumer Prices. Like the Federal Reserve, the ECB is
held accountable through releases of information, including the target interest rate
along with an explanatory statement, reports to the European Parliament, and
public speeches.

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8. Go to the ECB's web site and locate the most recent introductory statement made
by the president of the ECB at the press conference following a Governing
Council meeting. What was the Governing Council’s policy decision? How was
it justified? Is there any reference to financial stability measures?

Answer: On March 4, 21010 the Governing Council left key interest rates
unchanged, with the main refinancing rate at 1%. The president reported that
price developments remained subdued and that economic recovery was on track,
but was likely to remain uneven. In terms of the phasing out of non-standard
operational measures to promote financial stability, he announced that the main
refinancing operations and the special-term refinancing operations would remain
as fixed-rate tenders for the moment but that the Eurosystem would return to
variable rate tender procedures for its regular three-month longer-term refinancing
operations.

9. Do you think the FOMC has an easier or a harder time agreeing on monetary
policy than the Governing Council of the ECB? Why?

Answer: The presence of national biases is likely to make agreement among

members of the Governing Council of the ECB more difficult. By contrast, the
Federal Reserve has very little regional bias. Also, a group of 12 (the number of
voting FOMC members) is likely to have an easier time coming to a decision than
a group of 22 (the current number of ECB Governing Council members).

10. *What are the two most important factors in ensuring that power is decentralized
in the Eurosystem?

Answer: The ECB’s budget is controlled by the national central banks and the
executive board members are always a minority on the Governing Council.

11. Why did the “no-bailout” clause of the Maastricht Treaty come under stress
during the financial crisis of 2007-2009?

Answer: Large fiscal deficits in some Euro-area countries threatened the ability
of those Governments to borrow. A disruption to sovereign borrowing in one
country would not only cause economic difficulties in that country, but would
likely threaten the economies of all the Euro-area members due to the strong
inter-linkages between the economies of the member states.

12. The Monetary Policy Committee (MPC) of the Bank of England is responsible for
setting interest rates in the United Kingdom. Go to the Bank's web site at
http://www.bankofengland.co.uk, and get as much information about the MPC as

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you can. How big is it? Who are its members? How often does it meet? What
sort of announcements and publications does it offer? Is it independent of the
United Kingdom’s Parliament?

Answer: The MPC is made up of nine members, including a Governor, 2 Deputy

Governors, the Chief Economist of the Bank of England, the Executive Director
for Market Operations and 4 external members appointed by the Chancellor. It
meets every month. Its decisions about interest rates are released at 12 noon on
the second day of its meeting, and the minutes are released two weeks after the
interest rate decision. It also publishes a quarterly Inflation Report. In 1997, the
Bank of England became independent from the government, but the Chancellor
sets the inflation target.

Analytical Problems

13. Do you think the current procedures for appointing members to the Board of
Governors are consistent with the principles of good central bank design?
Explain your answer.

Answer: The length of the terms and the fact they are staggered reduces the
opportunity for political influence on the selection of the governors and so these
procedures are consistent with central bank independence. The governors are still
appointed by the president and confirmed by the senate, however. This can be
interpreted as a way of incorporating central bank independence with a
democratic society.

14. *Currently, all the national central banks in the Eurosystem are involved with the
implementation of monetary policy. What do you think the advantage would be
of centralizing the conduct of these day-to-day interactions with financial markets
at the ECB in Frankfurt? Are there any disadvantages you can think of?

Answer: The main advantage would be in terms of efficiency. Conducting these

interactions at 16 different national central banks is much more cumbersome that
having one central point of contact with financial markets. If would also promote
the treatment of the Eurosystem as one large integrated market as opposed to a
collection of separate national market segments. A possible disadvantage would
be the loss of local market knowledge, although this issue should become less and
less important over time.

15. If you were charged with re-drawing the boundaries of the Federal Reserve
districts, what criteria would you use to complete the task?

Answer: Some factors to consider would be that the districts would reflect a
diverse range of economic interests and that the district breakdown would reflect
the current population density in the districts.

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16. In February 2009, the Federal Reserve released for the first time a long run
forecast for inflation. Do you think this move will help the Federal Reserve
control inflation? Do you think it is equivalent to announcing a formal inflation
target?

Answer: The release of a long-term forecast for inflation can provide a “de-facto”
inflation target, helping to better anchor the public’s expectations of inflation and
thus stopping actual inflation from rising too high or falling too low. While the
forecast informs the public of the rate of inflation that FOMC participants see as
most consistent with their dual mandate, it is not equivalent to a formal target or
target range as it represents a range of individual targets rather than an agreed
target range.

17. Do you think the members of the ECB’s Governing Council should take formal
votes? Why or why not? If they do vote, how do you think the votes should be
allocated?

Answer: Taking formal votes would be a more practical approach to making

decisions, especially as the number of countries increases. One country, one vote
would become too cumbersome as more member countries join monetary union
and so a system of rotating voting members will come into place. The other issue
is whether large and small countries each receiving one vote would mean that
small countries might possibly have undue influence with the median country
being fairly small. The design of the system of rotation could mitigate this to
some extent.

18. If members of the ECB’s Governing Council do decide to take formal votes on
monetary policy decisions, do you think these votes should be published? Why or
why not?

Answer: Publication of the votes would add to transparency but might have
national political connotations. In the future, as the public and the markets
become more familiar and accepting of the fact that the decisions are based on the
economy of the euro area as a whole, this may become less of an issue.

19. Why do you think the statement released after each Federal Open Market
Committee meeting retains the same basic structure?

Answer: Maintaining the same structure for the statement promotes transparency
and is thought to be a good communication strategy. The market knows what
information it will be getting. If the structure of the statement constantly
changed, the markets might misinterpret these changes as signals about the stance
of policy that the committee did not intend to give.

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Chapter 16 - The Structure of Central Banks: The Federal Reserve and the European Central Bank

20. Do you think, in the interest of transparency, the Chair of the Federal Reserve
Board should explain in detail the subtleties surrounding policy decisions? Why
or why not?

Answer: There are often tradeoffs between transparency, credibility and good
communication strategy. While being more open about how policy decisions are
arrived at may, in some circumstances, enhance transparency, it is also possible
that too much information may make policy decisions less transparent and lead to
confusion in markets. Outlining all the competing factors that went into making a
policy decision may undermine the credibility of policymakers.

21. *If you were asked to design a new central bank, what two institutional design
features of (a) the Federal Reserve System and (b) the ECB would you adopt?
Explain your choices.

Answer: Features of the design of the Federal Reserve System to adopt might
include the centralization of the conduct of monetary policy and the publication of
the minutes of the FOMC meeting. These features promote efficiency and
transparency. Features of the design of the ECB to adopt might include the clear
definition of policy goals in terms of a hierarchical mandate and a numerical
definition of price stability and the holding of a press conference after the release
of monetary policy decisions. These features would help clarify policy goals and
the trade-offs between them, and promote transparency and accountability.

* indicates more difficult problems

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