Chapter 13 Federal Reserve

• Overview:

  • The chapter deals with the structure and activities of central banks, with a primary focus on the Federal Reserve System of the United States.

What is a Central Bank?

• Functions of a Central Bank:

  • Banker’s Bank: Provides services to the banking sector.

  • Lender of Last Resort: Offers emergency funds to banks facing liquidity issues.

  • Regulator: Oversees the banking system to maintain stability.

  • Government’s Bank: Acts as the bank for the government.

  • Controller of Money Supply: Implements monetary policy to manage the money supply in the economy.

Federal Reserve

• Historical Context:

  • Initial resistance to the establishment of a central bank characterized by:

  • Fear of centralized power.

  • Distrust of moneyed interests.

  • Absence of a lender of last resort led to bank panics, notably:

  • Panic of 1907: Highlighted the necessity of a central bank.

  • Federal Reserve Act of 1913: Instituted the Federal Reserve System with a structure featuring checks and balances while remaining decentralized.

• Structure of the Federal Reserve:

  • The Federal Reserve Act aimed to diffuse power along:

  • Regional lines.

  • Between the private sector and the government.

  • Among bankers, business people, and the public.

  • Entities included in the Federal Reserve System:

  • Federal Reserve District Banks

  • Board of Governors of the Federal Reserve System

  • Federal Open Market Committee (FOMC)

Federal Reserve District Banks

• Characteristics:

  • Function as quasi-public institutions owned by private commercial banks in their districts that are part of the Fed system.

  • Board of Directors:

  • Each district elects six directors; three additional directors are appointed by the Board of Governors.

    • Director Categories:

    • A Directors: Professional bankers.

    • B Directors: Prominent leaders from industry, labor, agriculture, or consumer sectors.

    • C Directors: Appointed by the Board of Governors, these members are prohibited from being bank officers, employees, or stockholders.

  • Directors elect the bank president, subject to Board of Governors approval.

• Functions of District Banks:

  • Clear checks.

  • Issue new currency and withdraw damaged currency from circulation.

  • Administer and make discount loans to banks in their districts.

  • Evaluate proposed mergers and bank activity expansions.

  • Serve as liaisons to the business community and the Federal Reserve.

  • Examine bank holding companies and state-chartered member banks.

  • Collect data on local economic conditions.

  • Employ professional economists for monetary policy-related research.

• Role of the New York District Bank:

  • Significance derived from:

  • Hosting many of the largest commercial banks in the US.

  • Involvement in bond and foreign exchange markets.

  • Unique membership as the only Federal Reserve Bank in the Bank for International Settlements (BIS).

  • The president serves as the only permanent voting member of the FOMC among Federal Reserve Bank presidents, acting as vice-chair alongside board leadership.

Board of Governors

• Composition:

  • Seven members based in Washington, D.C.

  • Appointed by the president and confirmed by the Senate.

  • 14-year non-renewable terms.

  • Members are required to represent different districts.

  • The chairman is designated from the governors, serving a four-year term.

• Responsibilities:

  • Votes on conducting open market operations.

  • Sets reserve requirements for banks.

  • Controls the discount rate through a structured review and determination process.

  • Sets margin requirements for borrowing against securities.

  • Determines salaries for Federal Reserve Bank presidents and officials while reviewing budgets.

  • Approves bank mergers and new applications for banking activities.

  • Specifies allowable activities for bank holding companies.

  • Oversees foreign banks operating within the US.

• Additional Roles:

  • Advises the president regarding economic policy.

  • Testifies before Congress.

  • Represents the Federal Reserve System in media engagement.

  • May represent the US in international economic negotiations.

• Research Importance:

  • The Federal Reserve employs the largest number of economists globally.

  • Economists analyze incoming economic data to inform policymakers about economic trends and potential impacts of monetary policies.

Federal Open Market Committee (FOMC)

• Operations:

  • Meets eight times annually.

  • Composed of:

  • Seven Board of Governors members.

  • President of the Federal Reserve Bank of New York.

  • Presidents from four additional Reserve banks.

  • The Chairman of the Board of Governors also chairs the FOMC.

  • Issues directives to the trading desk at the Federal Reserve Bank of New York.

• Power Dynamics:

  • Primary power resides with the Board of Governors, who hold significant influence over the District Bank Directors, including veto rights over District bank presidents.

  • Majority voting holds at FOMC meetings, indicating centralized decision-making authority in Washington, D.C.

Independence of the Federal Reserve

• Significance of Independence:

  • Central bank independence is crucial to prevent inflationary bias and influence from political cycles in monetary policy decisions.

  • Avoids risks associated with facilitating government funding for significant budget deficits.

  • Essential control of monetary policy to prevent principal-agent problems that can worsen within political environments.

• Arguments for Independence:

  • Reduces political pressure that may lead to biased inflationary measures.

  • Minimizes potential coordination challenges between fiscal and monetary policies.

  • Provides autonomy critical in managing economic conditions effectively.

• Critiques of Independence:

  • Perceived as undemocratic and unaccountable.

  • Difficulties emerge in synchronizing fiscal and monetary efforts.

  • Historical usage of independence has faced critiques regarding its effectiveness.

• The Federal Reserve's Performance:

  • The institution has notably succeeded in controlling inflation, particularly with advancements in data availability and technological improvements.

European Central Bank (ECB)

• Framework:

  • Established with a structure mimicking that of the Federal Reserve.

  • Central banks in member countries perform functions akin to those of Federal Reserve banks.

  • Notable structure includes:

  • Executive Board: Comprising a president, vice-president, and four additional members.

  • Each serves eight-year, non-renewable terms.

  • Governing Council oversees broader policies.

• Distinct Features:

  • National Central Banks maintain control over their individual budgets alongside the ECB.

  • Monetary operations remain uncentralized, lacking direct supervision over financial institutions.

• Independence of the ECB:

  • Among the most independent central banks globally, featuring long terms for Executive Board members.

  • Budgetary independence and legislative changes necessitate a revision of the Maastricht Treaty.

• Impact of the ECB and Euro on Member States:

  • Advantages of joining the Eurozone include:

  • Reduction in transaction costs.

  • Diminished inflation rates.

  • Lower interest rates.

  • Risks associated with Eurozone membership:

  • Loss of focus on individual nation’s monetary policy.

  • Reduced capacity to deflate currency, which complicates debt reduction and export encouraging strategies.