Unit 3

1. Unit 3 Structure of Central Banks and the Federal Reserve System

2. Origins of the Federal Reserve System • Resistance to establishment of a central bank • Fear of centralized power • Distrust of moneyed interests • First U.S. experiments with a central bank terminated in 1811 and in 1836 • 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

3. Problems with the Fractional Reserve Banking System • Lack of flexibility: • If a seasonal or panic-induced withdrawal of currency from banks occurred, pressure would converge on the larger banks as small banks drew down their deposits to obtain cash for their customers. • Major banking and financial market panics occurred in 1857, 1873, 1884, 1893, and 1907. • No lender of last resort stood ready to provide temporary cash reserves to the banking system in times of crisis. • The Fed was created by the Federal Reserve Act, which was signed into law by President Woodrow Wilson in December, 1913.

4. Federal Reserve Act • A compromise among diverse forces and interests: • between the government and the private sector; • among the various geographic regions of the nation; • between rural and urban interests, and • among bankers, the non-bank business sector, and the rest of society. • Original Mandate: • to serve as a lender of last resort to the banking system; • to issue currency; • to improve on the check collection process; • to serve as banker or fiscal agent for the U.S. Treasury, and • to improve the supervision and examination of the nation's banks. • Current Mandate: • Economic stabilization, • Price stabilization, and • Encouraging full employment.

6. The Structure Of The Federal Reserve System • 7-person Board of Governors: • appointed by the president of the United States for one 14-year term, subject to confirmation by the U.S. Senate • Major responsibilities include: • setting the levels of reserve requirements; • reviewing and "determining" the level of the discount rates set by the twelve individual district Federal Reserve banks; • establishing bank supervision and examination procedures; • evaluating applications for bank mergers and acquisitions; • setting margin requirements for the purchase of stocks and bonds, and • serving as voting members on the important Federal Open Market Committee (FOMC). • FOMC formulates the basic posture of monetary policy and buys and sells securities with a view toward influencing credit availability, short-term interest rates, and monetary conditions throughout the nation.

8. The District Federal Reserve Banks • Each district Federal Reserve Bank: • is an incorporated institution, owned by the Federal Reserve member banks of the district, and • is governed by a nine-person board of directors, six of whom are elected by commercial bankers and three of whom are appointed by the Board of Governors in Washington. • 3 professional bankers • 3 prominent business leaders • 3 representing areas other than banking and business sectors

9. 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

10. 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

11. 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)

12. Member Banks • All national banks are required to be members of the Federal Reserve System (currently about 7,800 commercial banks are members) • Commercial banks chartered by states are not required but may choose to be members • 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

13. 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

14. 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

15. 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.

16. 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

17. 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

18. FOMC Meeting • Report by the manager of system open market operations on foreign currency and domestic open market operations and other related issues • “Green Book” forecast • Go-round • Current monetary policy and domestic policy directive • “Blue book” • Presentation on relevant Congressional actions • Public announcement about the outcome of the meeting

19. Chairman 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

20. Allocation of Power within the Federal Reserve System • Board of Governors in Washington has more power than the district Federal Reserve banks. • Board of Governors in Washington can veto a districts choice of district Federal Reserve bank president. • Though the discount rate is set by each district Federal Reserve bank, it is subject to "review and determination" by the Board of Governors. • Decisions to purchase government securities are made in Washington by the FOMC. • Federal Reserve Bank of New York is the first among equals.

21. The Question Of Federal Reserve Independence • Relative to many other nations’ central banks, the Federal Reserve System enjoys considerable independence from governmental influence—either the executive or legislative branches. • The Fed's independence was created deliberately by the authors of the Federal Reserve Act. • Indicators of independence: • nonrenewable 14-year terms of the members of the Board of Governors, and • the Fed's operating revenues are derived from its portfolio of securities rather than from Congressional appropriations.

22. Other Central Banks • Bank of England least independent: Govt. makes policy decisions • European Central Bank: most independent—price stability primary goal • Bank of Canada and Japan: fair degree of independence, but not all on paper • Trend to greater independence: New Zealand, European nations

23. Independence of the Federal Reserve May be Overstated • The president appoints Chairmen and Board members and can influence legislation. • The Fed is frequently involved in Congressional legislation concerning bank regulation. • The Constitution grants authority to Congress to revoke the authority given to the Federal Reserve.

24. The Case For Federal Reserve Independence • An independent Fed likely has longer-run objectives, politicians don't. • Political business cycles • Less likely deficits will be inflationary. • Politicians love to spend money, but hate to levy taxes to pay for the expenditures. • Tendency to monetize fiscal deficit, leading to inflation. • An independent Fed guards price level stability.

25. The Case Against Federal Reserve Independence • Those responsible for monetary policy should be accountable to the electorate. • Various elements of national economic policy need to be coordinated • Fiscal and monetary policy • The Federal Reserve has not used its independence effectively over the years.

26. 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

27. Differences • 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

28. 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

29. ECB Independence • Most independent in the world • Long terms • Determines own budget • Less goal independent • Price stability • Charter cannot by changed by legislation; only by revision of the Maastricht Treaty

30. Central Bank Behavior • 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