Chapter 13 Central Banks and the Federal Reserve...

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Chapter 13

Central Banks and the Federal Reserve System

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.10-2

The Price Stability Goal

• Low and stable inflation

• Inflation

– Creates uncertainty and difficulty in planning for the future

– Lowers economic growth

– Strains social fabric

• Nominal anchor to contain inflation expectations

• Time-inconsistency problem


Other Goals of Monetary Policy

• High employment

• Economic growth

• Stability of financial markets

• Interest-rate stability

• Foreign exchange market stability


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

• Dual mandate


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


Federal Reserve Banks

• The Federal Reserve Act created 12 Federal Reserve districts, each with a district bank.

• Each district bank has a board of directors consisting of nine members.

• Subject to the board’s approval, the nine directors elect the president of that bank.

• The 12 Federal Reserve banks carry out many duties of the Fed.


Federal Reserve Districts


Formal Structure of the Fed


Informal Structure of the Fed


Ben BernankeAlan Greenspan


Member Banks

• The Federal Reserve Act required all national banks to become member banks.

• State banks were given the choice of whether or not to become members.


Board of Governors

• The Board of Governors is composed of seven members appointed by the President and confirmed by the U.S. Senate.

• Members serve 14-year, nonrenewable terms.

• It administers monetary policy.

• It has certain responsibilities relating to financial regulation.


Federal Open Market Committee

• The Federal Open Market Committee is composed of 12 members and directs the Fed’s open market operations.

• Members of the FOMC are the Board of Governors and five district bank presidents.

• The FOMC issues directives to the trading desk at the district bank in New York.



Power in the Fed

• The Board of Governors and the FOMC exert most of the Fed’s formal influence.

• The informal power of the chairman, the board staff, and the FOMC predominates.

• Member banks have little actual influence within the system.


Handling External Pressure

• The Fed was designed to operate independently of external pressures.

• In reality the Fed operates in a political arena, and is subject to political pressure.

• The President exercises pressure through his appointments to the Board of Governors.

• The Fed is the creation of Congress, which can amend the Fed’s charter and powers.


Factors that Motivate the Fed

• The public interest view holds that the Fed acts in the interest of the general public.

• The principal-agent view implies that the Fed acts to increase its power and prestige.

• The principal-agent view also implies there could be a political business cycle.

• The evidence in favor of a political business cycle is at best mixed.


Central Bank Independence

Factors making Fed independent

1. Members of Board have long terms

2. Fed is financially independent: This is most important

Factors making Fed dependent

1. Congress can amend Fed legislation

2. President appoints Chairmen and Board members and can influence legislation

Overall: Fed is quite independent


Comparison of Major Central Banks

• The Fed has the longest fixed term of office for bank board members (14 years).

• The Fed has the shortest term for the head of the central bank (4 years).

• Only Germany had a federal structure for the central bank. Deutsche Bundesbankhas greater independence than the Fed

• The overall degree of independence of the central bank varies.


Comparison of Major Central Banks

1. Bank of England least independent: Govt. makes policy decisions

2. European Central Bank: most independent—price stability primary goal

3. Bank of Canada and Japan: fair degree of independence, but not all on paper

4. Trend to greater independence: New Zealand, European nations


Fed Independence

• The issue of the Fed’s independence arises

because of negative reaction to Fed policy.

• Proponents for Fed independence argue that politicians would do a poor job.

• Opponents of Fed independence claim that elected officials should make public policy.


Should Fed be Independent?

Should Fed be Independent?Case For:1. Independent Fed likely has longer-run

objectives, politicians don't: evidence is independence produces better policy outcomes throughout the whole

2. Avoids political business cycle3. Less likely deficits will be inflationary


Should Fed be Independent?

Case Against:

1. Fed may not be accountable

2. Hinders coordination of monetary and fiscal policy

3. Fed has often performed badly


Central Bank Independence in Other Countries

• Central bank independence is becoming greater.

• Countries with the most independent central banks have the lowest average rates of inflation.


The People’s Bank of China

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Chapter 13 Central Banks and the Federal Reserve...

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