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The Organization of The Fed and other Central Banks

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1 The Organization of The Fed and other Central Banks

2 A Brief History of Central Banks
A Central Bank is an entity responsible for overseeing a nation’s banking system, acting as a lender of last resort, conducting monetary policy, and maintaining currency stability. The two oldest Central Banks are the Swedish Riksbank (1668) and the Bank of England (1694), though elements of Central Banking have been around since the introduction of fiat money by the Mongols in the 13th century. The Central Bank in the U.S., the Federal Reserve System, was not created until 1913 Fear of centralized power along with a distrust of moneyed interests halted earlier attempts at creating a central bank A series of bank failures, culminating in panic of 1907 overcame these fears and paved the way for the “Fed.” To limit the centralization of power or influence by any one group, the Fed was subjected to checks and balances among private vs. public interests as well as national vs. regional

3 Checks and Balances at the Fed

4 The Federal Reserve System

5 Federal Reserve Banks Quasi-public institution owned by private commercial banks in the district that are members of the Fed system Member banks purchase stock in their regional Federal Reserve Bank as a requirement of membership Member banks elect six directors (A and B) for each district; three more (C) 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 These nine directors at each bank then nominate a bank president to be confirmed by the Board of Governors By drawing directors from all sectors of the economy, no one industry can dominate the Fed’s actions

6 The Functions of each Federal Reserve Bank
Clear checks Issue new currency Withdraw damaged currency from circulation Manage discount loans to banks in each district Evaluate and advise on M&A activity between banks in each district Connect the local business community and the Federal Reserve System Examine and advise local banks Collect data on local business conditions Conduct research into the conduct of monetary policy

7 Monetary Policy and the Fed
The directors of the Federal Reserve Banks establish the discount rate at which commercial banks borrow from the Fed. The Board of Governors have the right to review and determine this rate. The directors also decide which banks (both members and non-members) may borrow from the Fed at this discount rate The directors select one commercial banker from each district to sit on the Federal Advisory Council, which advises the Board of Governors about monetary policy ***Five of the bank presidents has a vote (along with the seven members of the Board of Governors) in the Federal Open Market Committee, the main arm of monetary policy*** All twelve bank presidents attend FOMC meetings, but only five vote. One vote always goes to the president of the New York Fed, while the other four rotate on an annual basis.

8 The Members of the Fed All national commercial banks are required to be members of the Federal Reserve System A national bank operates in more than one state and is chartered by the Office of the Comptroller of the Currency. Membership entails purchasing stock in the commercial bank’s regional Federal Reserve Bank This stock cannot be traded or sold and pays a fixed 6% annual dividend. State-chartered banks can be members of the Fed, but are not required to do so. In the past, many state-chartered banks preferred not to become Fed members since they didn’t want to keep reserves as deposits at the Fed (where they earned no interest) The Depository Institutions Deregulation and Monetary Control Act of 1980 required all commercial banks (members and non-members alike) to abide by the same reserve requirements. The majority of banks in the US are not members of the Fed, but majority of assets are controlled by members.

9 Members and Non-Members of the Fed
National Bank State Bank (Member) State Bank (Non-Member)

10 The Board of Governors Seven of the twelve votes on the FOMC go to the Board of Governors of the Federal Reserve System Each governor is appointed by the US President and confirmed by the US Senate to a single (non-renewable) 14 year term The seven governors must come from different districts to prevent regional dominance The Chairman of the Board of Governors is selected from this group and subject to reappointment every four years by the U.S. President. The Board has the most policy control in the Fed as it has… A voting majority in the FOMC Sets reserve requirements within legislative limits Effectively controls the discount rate with its mandate to “review and determine” the rate set by the 12 Regional Banks.

11 The FOMC When the media reports that “the Fed met to lower interest rates,” what they are really talking about is the FOMC The FOMC meets eight times per year (every six weeks) on a Tuesday. The FOMC is made up of the seven-member Board of Governors and five Regional Bank presidents (one of whom is always the president of the NY Fed) The other seven Bank presidents attend and participate in discussions, but do not vote. The FOMC meetings set a “Federal Funds Rate” that will be targeted through the Open Market Operations of buying and selling treasury bonds from/to the public.

12 The FOMC At each FOMC meeting, three important reports are discussed:
The “Green Book” presents forecasts by the Fed research staff on the state of the economy over the next two years The “Blue Book” presents a favored monetary policy objective as well as three alternative policies to be considered. The “Beige Book” presents surveys and reports on the state of the economy in each of the twelve districts. Upon voting (generally in agreement with the Chairman), a public announcement is made about the outcome of the meeting as well as the economic trends prompting any policy changes The public announcement is a new development since 1994 and represents a growing trend toward transparency. The Chairman has a very powerful position within the FOMC (and by extension, the FED) Spokesperson for the Fed in talks with Congress and the US President Sets the agenda for meetings Speaks and votes first about monetary policy Supervises the professional economists from whose ranks the Board of Governors is most frequently selected.

13 The European Central Bank
For much of the post-WWII period, the Fed was the most important central bank in the world. This hegemony has been challenged since 1999 with the creation of the European Central Bank (ECB) and European System of Central Banks (ESCB) Following the mandates laid out in the Maastricht Treaty of 1992, eleven countries adopted a single currency (the euro) and ceded control of monetary policy to the ECB in January 1999. There are now fifteen countries using the euro, with more slated to join over the next decade. Each country’s central bank stayed in business, but now operates much like the Regional Reserve Banks in the US do. Monetary Policy is established at the ECB, by the Governing Council The Executive Board consists of the President and Vice President of the ECB along with four other members appointed to eight year non-renewable terms The fifteen presidents of the National Central Banks


15 Central Bank Independence
Consider three measures of Central Bank Independence: Instrument independence  the central bank is free to set any monetary policy instrument/variable Goal independence  the central bank is free to set its own goals for monetary policy Political independence  the central bank is able to conduct monetary policy without legislative influence Both the Fed and the ECB are considered to be very independent central banks The ECB has less goal independence as it has a mandate to promote price stability (2% inflation target recently) However, changes to the ECB cannot be made without a unanimous change to the Maastricht Treaty (by 15 countries!) Changes to the Fed may be made by a simple act of Congress. Political independence is built into the structure of these organizations Long and non-renewable terms Financed out of their own revenues rather than by legislative approval

16 Should central banks be independent of political influence?
The strongest argument for independence is that an independent central bank is insulated from the political pressures of re-election Fiscal policy tends to follow a “political business cycle” inflationary during an election year, contractionary afterwards. If central banks were subject to political approval, monetary policy would also follow this volatile pattern Another argument in favor of central bank independence is that elected politicians do not have the technical savvy to conduct monetary policy Proponents of this view contrast the efficiency of a Federal Reserve run by bureaucrats with the bloated Federal budget (often in deficit) run by politicians If the central bank was beholden to political interests, the federal government could amass large budget deficits then turn to the Fed to pay off its debts (essentially printing up more money for the government to pay off its debts) Every time this has happened in history, massive inflation and financial crises have been the result.

17 Should central banks be independent of political influence?
Is it democratic to have monetary policy for the entire nation in the hands of an “elite” group responsible to no one? If the Fed performs badly, there are few ways to replace its members (unlike Congress where the people can vote out underperforming legislators) If policy is best conducted by technically savvy elites, then why aren’t all military decisions made by the Joint Chiefs of Staff, all tax policy decisions made by the IRS, all environmental regulations made by the EPA, etc.? This criticism gains credence when you consider that the Fed has been a poor steward of the economy at times (failing to act early enough during the Great Depression, inflating the economy during the 1960’s.) Close coordination between monetary and fiscal policy would achieve the most effective results. The best way to coordinate both types of policies would be to have them controlled by the same group.

18 Should central banks be independent of political influence?
The empirical evidence on central bank independence is mixed Some studies find evidence that the countries with the lowest inflation rates are the most independent Other studies argue that while this is true, it is low inflation rates that are causing central banks to become independent

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