Chapter 13

Central Banks and

the Federal
Reserve System

Origins of the Federal Reserve

System
Resistance to establishment of a central bank
Fear of centralized power
Distrust of moneyed interests
First Bank of US disbanded in 1811, Second Bank of US
Charter vetoed by Andrew Jackson in 1832

Resistance Led to No lender of last resort

(Big problem)
Nationwide bank panics on a regular basis
Panic of 1907 so severe that the public was
convinced a central bank was needed

13-2

2013 Pearson Education, Inc. All rights reserved.

Origins of the Federal Reserve

System
Federal Reserve Act of 1913
Despite the need for a lender of last resort, there
was still (and still is) resistance to a central
banking authority
Elaborate system of checks and balances
Decentralized (12 branches, board of governors,
etc.)

13-3

2013 Pearson Education, Inc. All rights reserved.

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
This initial diffusion of power has resulted in the
evolution of the Federal Reserve System to include
the following entities:
The Federal Reserve banks, the Board of Governors of the
Federal Reserve System, the Federal Open Market
Committee (FOMC), the Federal Advisory Council, and
around 2,900 member commercial banks.

13-4

2013 Pearson Education, Inc. All rights reserved.

Figure 1 Structure and Responsibility for

Policy Tools in the Federal Reserve System

13-5

2013 Pearson Education, Inc. All rights reserved.

Figure 2 Federal Reserve System

Source: Federal Reserve Bulletin.

13-6

2013 Pearson Education, Inc. All rights reserved.

Federal Reserve Banks

12 Federal Reserve Banks
Quasi-public (part private, part public) institution owned
by private commercial banks in the district that are
members of the Fed system
Member banks purchase stock, which is limited to dividends of
6% annually
Largest Banks are NY, Chicago, and San Francisco
The New York Fed's three-story high cash storage vault is the
size of a football field. If filled with $100 bills, it can hold a total
of $350 billion. The large cash vault is unmanned. Robots are
used to transport cash.
Has over $100 billion of the Worlds gold (more than Fort Knox)
NY Fed also houses the open market desk, carries out open
market activates

13-7

2013 Pearson Education, Inc. All rights reserved.

Federal Reserve Banks

Member banks elect six directors for each district;
three more are appointed by the Board of
Governors
Three A directors are professional bankers
Three B directors are prominent leaders from industry,
labor, agriculture, or consumer sector
Three C directors appointed by the Board of Governors
are not allowed to be officers, employees, or stockholders
of banks

13-8

2013 Pearson Education, Inc. All rights reserved.

Federal Reserve Banks (contd)

Member banks elect six directors for each district; three more
are appointed by the Board of Governors (contd)
Designed to reflect all constituencies of the public

One of the most important functions of the Nine directors is to

appoint the president of the bank subject to approval by
Board of Governors
Since Dodd-Frank Act of 2010, class A directors are no longer involved in
this due to potential conflicts of interest.

13-9

2013 Pearson Education, Inc. All rights reserved.

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

13-10

2013 Pearson Education, Inc. All rights reserved.

Functions of the Federal Reserve

Banks (contd)
Act as liaisons between the business community
and the Federal Reserve System
Examine bank holding companies and statechartered member banks
Collect data on local business conditions
Use staffs of professional economists to research
topics related to the conduct of monetary policy

13-11

2013 Pearson Education, Inc. All rights reserved.

Federal Reserve Banks and

Monetary Policy
Directors establish the discount rate
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)

13-12

2013 Pearson Education, Inc. All rights reserved.

A Note on the Discount Rate

The discount rate is the interest rate
charged to commercial banks and other
depository institutions on loans they receive
from their regional Federal Reserve Bank's
lending facility--the discount window.
The Federal Reserve Banks offer three
discount window programs to depository
institutions: primary credit, secondary
credit, and seasonal credit, each with its
own interest rate.
13-13

2013 Pearson Education, Inc. All rights reserved.

A Note on the Discount Rate

All discount window loans are fully secured.
Under the primary credit program, loans are
extended for a very short term (usually
overnight) to depository institutions in
generally sound financial condition.
Depository institutions that are not eligible
for primary credit may apply for secondary
credit to meet short-term liquidity needs or
to resolve severe financial difficulties.

13-14

2013 Pearson Education, Inc. All rights reserved.

A Note on the Discount Rate

Seasonal credit is extended to relatively
small depository institutions that have
recurring intra-year fluctuations in funding
needs, such as banks in agricultural or
seasonal resort communities.

13-15

2013 Pearson Education, Inc. All rights reserved.

Member Banks
All national banks are required to be members of
the Federal Reserve System
Commercial banks chartered by states are not
required but may choose to be members
Currently 1/3 of commercial banks are members
Prior to 1980 only member banks were required to
keep a portion of deposits at Fed banks
At the time there was no interest paid on these
deposits, it was costly to hold money at Fed,
especially if interest rates rose

13-16

2013 Pearson Education, Inc. All rights reserved.

Member Banks
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
Today interest is paid out on deposits (very low),
this came out of the Great Recession of 20072009.

13-17

2013 Pearson Education, Inc. All rights reserved.

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 (renewable)
13-18

2013 Pearson Education, Inc. All rights reserved.

Duties of the Board of Governors

Conduct Monetary Policy
Votes on conduct of open market operations
Sets reserve requirements
Controls the discount rate through review and determination
process
Sets margin requirements
The fraction of the purchase price for securities that must
be paid in cash, as opposed to borrowed funds
Sets salaries of president and officers of each Federal Reserve
Bank and reviews each banks budget

13-19

2013 Pearson Education, Inc. All rights reserved.

Duties of the Board of Governors

(contd)
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.

13-20

2013 Pearson Education, Inc. All rights reserved.

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

13-21

2013 Pearson Education, Inc. All rights reserved.

Federal Open Market Committee

(FOMC)
Meets eight times a year, making decisions about open
market operations
Sets federal funds rate, the interest rate at which overnight
loans from one bank to another are made

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

13-22

2013 Pearson Education, Inc. All rights reserved.

FOMC Meeting
Report by the manager of system open market
operations on foreign currency and domestic open
market operations and other related issues
Presentation of Boards staff national economic
forecast
Outline of different scenarios for monetary policy
actions
Presentation on relevant Congressional actions
Public announcement about the outcome of the
meeting

13-23

2013 Pearson Education, Inc. All rights reserved.

FOMC Meeting
It is at these meetings where monetary policy
decisions are made
Tighter policy (higher interest rates) or
expansionary policy (lower interest rates)
Note that the FOMC doesnt set reserve
requirements or discount rate, but these decisions
are essentially made at these meetings
FOMC doesnt carry out open market operations,
but issues directives to the trading desk at the NY
Fed
Manager for domestic open market operations at NY Fed
supervises purchases and sales of govt securities
13-24

2013 Pearson Education, Inc. All rights reserved.

Why the Chairman of the Board of

Governors Really Runs the Show
Spokesperson for the Fed and negotiates
with Congress and the President
Sets the agenda for meetings
Speaks and votes first about monetary
policy
Supervises professional economists
and advisers

13-25

2013 Pearson Education, Inc. All rights reserved.

How Independent is the Fed?

Instrument and goal independence.
Instrument: The ability to set monetary policy
instruments
Goal: The ability to set goals of monetary policy

Independent revenue
Revenue from interest on loans to banks, securities
holdings, etc.
In 2010, the fed had a net revenue of $80 billion
(most gets returned to US Treasury)
This income allows Fed to not be controlled by the
power of the purse wielded by congress (most
significant factor that makes Fed independent)
13-26

2013 Pearson Education, Inc. All rights reserved.

How Independent is the Fed?

Feds structure is written by Congress, and
is subject to change at any time.
2009 Congressman Ron Paul sponsored a bill to
subject the Fed to audits by the Government
Accountability Office (GAO)

Presidential influence
Influence on Congress
Appoints members
Appoints chairman although terms are not
concurrent

13-27

2013 Pearson Education, Inc. All rights reserved.

Should the Fed Be Independent?

The Case for Independence
The strongest argument for an independent
central bank rests on the view that subjecting It
to more political pressures would impart an
inflationary bias to monetary policy

The Case Against Independence

-Proponents of a Fed under the control of the

president or Congress argue that it is undemocratic
to have monetary policy (which affects almost
everyone in the economy) controlled by an elite
group that is responsible to no one

13-28

2013 Pearson Education, Inc. All rights reserved.

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 politiciansthe
principal-agent problem is worse for
politicians

13-29

2013 Pearson Education, Inc. All rights reserved.

The Case Against Independence

Undemocratic
Unaccountable
Difficult to coordinate fiscal and monetary
policy
Has not used its independence successfully

13-30

2013 Pearson Education, Inc. All rights reserved.

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
The theory of bureaucratic behavior may be a
useful guide to predicting what motivates the Fed
and other central banks

13-31

2013 Pearson Education, Inc. All rights reserved.

Explaining Central Bank Behavior

(contd)
Theory of bureaucratic behavior:
objective is to maximize its own welfare
which is related to power and prestige
Fight vigorously to preserve autonomy
Avoid conflict with more powerful groups

Does not rule out altruism

13-32

2013 Pearson Education, Inc. All rights reserved.

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
President, vice-president and four other
members
Eight year, nonrenewable terms

Governing Council

13-33

2013 Pearson Education, Inc. All rights reserved.

Differences Between the European System

of Central Banks 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

13-34

2013 Pearson Education, Inc. All rights reserved.

Governing Council
Monthly meetings at ECB in Frankfurt,
Germany
Twelve National Central Bank heads and
six Executive Board members
Operates by consensus
ECB announces the target rate and takes
questions from the media
To stay at a manageable size as new
countries join, the Governing Council will
be on a system of rotation
13-35

2013 Pearson Education, Inc. All rights reserved.

How Independent Is the ECB?

Most independent in the world
Members of the Executive Board have long
terms
Determines own budget
Less goal independent
Price stability

Charter cannot by changed by legislation;

only by revision of the Maastricht Treaty

13-36

2013 Pearson Education, Inc. All rights reserved.

Structure and Independence of

Other Foreign Central Banks
Bank of Canada
Essentially controls monetary policy

Bank of England
Has some instrument independence.

Bank of Japan
Recently (1998) gained more independence

The trend toward greater independence

13-37

2013 Pearson Education, Inc. All rights reserved.