Econ module 7 chapter 15: The Federal Reserve Banking System and Central Banks

The Federal Reserve Banking System and Central Banks

A central bank is the organization responsible for conducting monetary policy and ensuring that a nation’s financial system operates smoothly.
The primary goals of a central bank through monetary policy are to influence macroeconomic policy to achieve low unemployment and low inflation by deciding whether to raise or lower interest rates.
Responsibilities of the central bank include:
- Regulating all or part of the nation’s banking system.
- Protecting bank depositors.
- Insuring the health of the bank’s balance sheet.
Notable global central banks include:
- The European Central Bank.
- The Bank of Japan.
- The Bank of England.
In the United States, the central bank is known as the Federal Reserve, often abbreviated as “the Fed.”

Structure and Organization of the Federal Reserve

The Federal Reserve is described as semi-decentralized, blending government appointees with private-sector bank representation.
At the national level, the Fed is managed by the Board of Governors.
The Board of Governors consists of seven members appointed by the President of the United States and confirmed by the Senate.
Terms for governors are $14$ years, arranged so one term expires on January $31$ of every even-numbered year.
The purpose of long, staggered terms is to insulate the Board from political pressure, allowing decisions based strictly on economic merit.
Each member serves only one term, except when filling an unfinished term.
Policy decisions do not require congressional approval; the President cannot demand a governor's resignation as they can with cabinet-level positions.
One member is designated as the Chair of the Federal Reserve Board of Governors:
- Alan Greenspan ( $1987$ to early $2006$ ).
- Ben Bernanke ( $2006$ to $2014$ ).
- Janet L. Yellen ( $2014$ to $2018$ ): The first woman to hold the post. She holds a Ph.D. in economics from Yale and taught at Harvard, the London School of Economics, and UC Berkeley. She previously served as President of the Federal Reserve Bank of San Francisco ( $2004$ - $2010$ , warned of the housing bubble) and Chair of the Council of Economic Advisors.
- Jerome Powell (Current Chair since early $2018$ ): Holds a B.A. in politics from Princeton and a law degree from Georgetown. He was a lawyer and investment banker, Assistant Secretary and Under Secretary of the Treasury, and is Chairman of the Federal Open Market Committee (FOMC).
The Chair is “first among equals”: though they have only one vote, they control the agenda and serve as the Fed's public voice.
The Federal Reserve System also includes $12$ regional Federal Reserve banks, supporting commercial banks and the economy in their specific districts.
Commercial banks in each district elect a Board of Directors for their regional Fed bank, which in turn chooses a president for that district.

Functions of the Central Bank

The Federal Reserve performs three primary functions:
1. Conducting monetary policy.
2. Promoting stability of the financial system.
3. Providing banking services to commercial banks, depository institutions, and the federal government.
Banking services provided to commercial banks include:
- Maintaining accounts where banks deposit reserves.
- Providing loans through the “discount window” facility.
- Processing checks: The Fed handles the return of checks (or images) and the transfer of funds between accounts when a check is deposited.
- Ensuring adequate circulation of currency and coins to meet public demand (e.g., increasing supply for the Christmas season and reducing it in January).

Bank Regulation and Supervision

Bank regulation is intended to maintain solvency by avoiding excessive risk.
Regulation categories include:
- Reserve Requirements: Banks must hold a minimum percentage of deposits as reserves. Most are held in the bank's account at the Federal Reserve to cover withdrawals.
- Capital Requirements: Regulation of bank capital (net worth), defined as the difference between assets and liabilities. Banks must maintain a minimum net worth as a percentage of assets to remain solvent.
- Investment Restrictions: Banks can make loans and buy U.S. Treasury securities but are prohibited from investing in the stock market or other assets deemed too risky.
Consumer Protection Laws: The Fed ensures banks do not discriminate (based on age, race, sex, or marital status) and require public disclosure of home loan distribution geographically and demographically.
Supervision Agencies:
- Office of the Comptroller of the Currency (OCC): Monitors/regulates about $1,500$ of the largest national banks and foreign branches in the U.S., plus about $800$ savings and loan institutions.
- National Credit Union Administration (NCUA): Supervises over $6,000$ credit unions (nonprofit banks owned by members).
- Federal Reserve: Supervises “bank holding companies” (conglomerate firms owning banks and other businesses).
Supervision Outcomes: Supervisors can require behavior changes or force a bank to close/sell if it has low net worth or excessive risky loans.
Challenges in Supervision:
- Practical: Difficulty in measuring the value of loans (assets) based on repayment risk, especially with complex international deals.
- Political: Closing a bank is controversial and can lead to political pressure from owners or local politicians to “back off” (e.g., Japan in the $1990$ s).

Bank Runs and Protection Strategies

A bank run occurs when depositors race to a bank to withdraw funds for fear the bank will fail. Because banks loan out most deposits, they cannot meet the demand of a large-scale run even if they are solvent.
Historical Context: Bank runs caused instability in the $19$ th and early $20$ th centuries (Great Depression). The movie “It’s a Wonderful Life” depicts this scenario.
Protection Strategies:
- Deposit Insurance: In the U.S., the Federal Deposit Insurance Corporation (FDIC) guarantees deposits up to $250,000$ per account. Banks pay premiums based on deposit volume and riskiness (e.g., safely held banks paid $10$ - $20$ cents per $100$ , while risky ones paid $50$ - $60$ cents in $2009$ ). Since the $1930$ s, no one has lost insured deposits.
- Lender of Last Resort: The Fed stands ready to lend to solvent but illiquid banks when they cannot obtain funds elsewhere, preventing failure from spreading. This was used during the $1987$ stock market crash and the $2008$ - $2009$ recession.

Traditional Tools of Monetary Policy

The Fed manages interest rates and credit conditions for economic activity (Congress delegated this power via the $1913$ Federal Reserve Act).
1. Open Market Operations (Most Common Tool):
- Buying or selling U.S. Treasury bonds.
- Targeted Interest Rate: The Federal Funds Rate (the rate banks charge each other for overnight loans).
- Federal Open Market Committee (FOMC): Makes decisions. Includes $7$ Board of Governors members and $5$ regional bank presidents (NY president is permanent; others rotate annually).
- Expansionary OMO: Fed buys bonds $→$ reserves increase $→$ banks loan more $→$ money supply increases via the money multiplier.
- Contractionary OMO: Fed sells bonds $→$ banks pay for bonds with reserves $→$ reserves decrease $→$ loans decrease $→$ money supply decreases.
2. Changing the Discount Rate:
- The discount rate is the interest rate the Fed charges banks for loans through the discount window.
- Raising the rate makes borrowing from the Fed more expensive $→$ banks reduce borrowing/loans $→$ money supply falls.
- Lowering the rate has the opposite effect.
- Impact is limited because banks are expected to borrow from other banks first and the discount rate is usually higher than the federal funds rate.
3. Changing Reserve Requirements:
- If requirements are raised, banks have less to lend. If lowered, they have more.
- $2015$ Example: $0$ % on first $14.5$ million; $3$ % up to $103.6$ million; $10$ % above that.
- Rarely used for large policy shifts due to extreme disruption to banking operations.

Monetary Policy and Economic Outcomes

Expansionary (Loose) Monetary Policy: Reduces interest rates, stimulates borrowing, increases AD. Shifts the supply of loanable funds right.
Contractionary (Tight) Monetary Policy: Increases interest rates, reduces borrowing, decreases AD. Shifts the supply of loanable funds left.
Interest Rate Effects: Though the Fed targets the federal funds rate, this influences the entire spectrum of rates (cars, houses), though to a lesser degree for long-term loans.
Countercyclical Policy:
- Recession/Unemployment: Use expansionary policy to shift AD right toward potential GDP.
- Inflationary Pressures: Use contractionary policy to shift AD left toward potential GDP.
Overreaction Risks: Excessively loose policy can trigger inflation; excessively tight policy can cause recession.

Historical Action Episodes (1975–2008)

Episode 1 (Late 1970s): High inflation (>10%). Fed raised funds rate from $5.5$ % to $16.4$ %. Inflation fell to $3.2$ % by $1983$ , but back-to-back recessions occurred; unemployment hit $9.7$ %.
Episode 2 (Early 1980s): Slashing rates ( $16.4$ % to $6.8$ %) to reduce unemployment as inflation declined to $2$ %.
Episode 3 (Late 1980s): Tighter policy (rates $6.6$ % to $9.2$ %) to stop creeping inflation ( $2$ % to $5$ %). Caused $1990$ - $1991$ recession; unemployment rose to $7.5$ %.
Episode 4 (Early 1990s): Confident in inflation control, Fed cut rates ( $8.1$ % to $3.5$ %). Unemployment fell to <5% by $1997$ .
Episodes 5 & 6 (Mid 1990s/Late 1990s): Rate hikes to prevent inflation (hike to $5.8$ % in $1995$ ; hike to $6.5$ % in $2000$ ). Recession occurred in $2001$ .
Episodes 7 & 8 (Early 2000s): Loose policy (rates slashed to $1$ % in $2003$ ) due to fear of Japan-style deflation. Rates raised back to $5$ % by $2007$ .
Episode 9 (2008): Great Recession. Fed slashed rates to nearly $0$ % by $2009$ .

Quantitative Easing (QE)

Defined as the purchase of long-term government and private mortgage-backed securities to make credit available when short-term interest rates are at the “zero bound.”
Differs from traditional OMO: Targets long-term rates and includes private assets (“toxic assets” like MBS) to strengthen bank balance sheets.
Three Episodes:
- QE1 (Nov 2008): Fed purchased $600$ billion in MBS from Fannie Mae and Freddie Mac.
- QE2 (Nov 2010): Fed purchased $600$ billion in U.S. Treasury bonds.
- QE3 (Sept 2012): Purchase of $40$ billion/month in MBS (increased to $85$ billion/month in Dec $2012$ ). Ended Oct $2014$ .
Outcomes: QE1 was somewhat successful; QE2 and QE3 were less so. Bank reserves quintupled.

Pitfalls and Limitations of Monetary Policy

Time Lags: Policy takes time to percolate ( $1$ to $3$ years) through perception, meeting, decision, banking system shifts, and business/consumer borrowing changes.
Excess Reserves: In a recession, banks may hold more than the legal minimum (excess reserves) due to fear of defaults. Expansionary policy fails if banks won't lend (the “pushing on a string” analogy).
- Japan Example: $1990$ s- $2000$ s, rates at $0$ % and money supply up $50$ %, but AD didn't stimulate.
Predictability of Velocity: Velocity is the speed money circulates: $\text{Velocity} = \frac{\text{Nominal GDP}}{\text{Money Supply}}$ .
- The Basic Quantity Equation of Money: $\text{Money Supply} \times \text{Velocity} = \text{Price Level} \times \text{Real GDP}$ .
- If velocity is constant (like $1960$ - $1980$ ), money supply changes have predictable effects.
- Since the $1980$ s, velocity has been unpredictable due to electronic banking and financial innovations.
Monetarist View (Milton Friedman): Argued for a constant money supply growth rate (e.g., $3$ % per year) to match real growth and prevent instability.

Economic Outlooks and Goals

Neoclassical View: Monetary policy has no long-run effect on GDP or unemployment (vertical AS curve); it only affects the price level. Focus should be low inflation.
Inflation Targeting: Legal requirement for central banks to focus solely on low inflation (e.g., $28$ countries by $2014$ , including UK, Canada, Brazil). The U.S. Fed is an exception, required to consider both inflation and unemployment.
Asset Bubbles and Leverage Cycles:
- The “dot-com” boom ( $1994$ - $2000$ ) and housing bubble ( $2003$ - $2005$ ) were not sustainable.
- Leverage Cycle: In good times, high lending exaggerates growth; in bad times, the sudden reduction in credit (“deleveraging”) worsens the downturn.
- Controversial Action: Central banks hesitate to intervene in bubbles due to political backlash and the difficulty of defining “right” prices.
Deflation: Negative inflation makes real interest rates high (Real Rate = Nominal Rate -$ – Inflation Rate). If inflation is $-$ 5 $% and nominal is$ 0 $%, real is$ 5 $%. This causes defaults and bank failures (Great Depression,$ 6.7 $% annual deflation).\n\n# Quantitative Calculation Exercise\n\n- Scenario: Initial money supply ($ M $) =$ 4 $trillion; Velocity ($ V $) =$ 3 $; Initial Price Level ($ P $) =$ 100.\n- Step 1: Solve for initial Quantity (Q $).$ 4,000 \times 3 = 100 \times Q \rightarrow Q = 120.\n- Step 2: Fed adds 800 $billion ($ M $now$ 4.8 $trillion) and price level rises to$ 110 $. Solve for new$ Q $.$ 4,800 \times 3 = 110 \times Q \rightarrow Q = 130.9.\n- Step 3: Impact is an increase of 10.9$$ billion in the quantity of goods and services.