Structures of Central Banks and the Federal Reserve System The Economics of Money, Banking, and Financial Markets Mishkin, 7th ed. Chapter 14 Structures of Central Banks and the Federal Reserve System

Origins of the Fed Created in response to series of bank panics 12 Federal Reserve Districts – compromise between those who favored and those who opposed a central bank

Formal Structure of the Fed

Federal Reserve Districts

Federal Reserve District Banks One main bank in each district Federal Reserve Bank of NY – holds 25% of Fed’s assets Federal Reserve Banks of New York, Chicago, and San Francisco hold over 50% of the Fed’s assets Federal Reserve District Bank Directors: 3 Class A – professional bankers (elected by member banks) 3 Class B – leaders of local industry, labor, agriculture, or the consumer sector in the region (elected by member banks) 3 Class C – public interest – appointed by the Board of Governors

Functions of the Federal Reserve District Banks Check clearing Issuing new currency Withdrawing damaged currency from circulation Administer and make discount loans Evaluate proposed mergers and applications for banks to expand their activities Act as liaisons between business community and the Fed Collect data on business conditions Conduct economic research

Federal Reserve District Banks and monetary policy “establish” discount rate in their region (role taken over by the Board of Governors) Decide which banks can receive discount loans One banker from each district is selected for membership on the Federal Advisory Council. FRB of New York and other four of the rest 11 FRB presidents have a vote on the Federal Open Market Committee

Membership in the Fed All national banks must be members Depository Institutions Deregulation and Monetary Control Act of 1980 by 1987, all banks are required to keep some reserves in the Fed. All banks have access to discount loans and Fed check clearing

Board of Governors 7 members, 14-year “nonrenewable” term. Functions: Set reserve requirement (and margin requirements) Effectively sets the discount rate Participates in setting open-market operations (all members are on the Federal Open-Market Committee) Supervision and regulation of banking system

Federal Open Market Committee 12 members: 7 Board of Governors 5 District Bank Presidents (always including the NY Fed President) Typically meets 8 times a year (every 6 weeks) Establishes open market policy

Evolution of Fed power Over time, the power to conduct monetary policy has been centralized in the Board of Governors.

Informal Structure of the Fed

Central Bank Independence Instrument independence – ability to determine the instruments of monetary policy Goal Independence – ability to set the goals Does the Fed have both? Why might independence be desirable? Elected authorities bias toward inflationary policies? Is the Fed autonomous? Term structure of the board Independent source of funds Who granted this autonomy? Factors making Fed independent Members of Board have long terms Fed is financially independent: This is most important Factors making Fed dependent Congress can amend Fed legislation President appoints Chairmen and Board members and can influence legislation Overall: Fed is quite independent

Other central banks 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 Bank of Canada – in 1967, monetary power is officially given to the government, yet the Bank still essentially controls the money supply (the minister of finance may issue a directive on monetary policy, but none has yet been issued) Bank of England – least independent until 1997. In 1997, the Bank was given the power to set interest rates. The government may overrule the Bank “under extreme conditions” and “for a limited period.”

Other central banks (cont.) Bank of Japan – Independent since 1998 – goal of price stability European Central Bank a role similar to that of the Fed. Central Banks of each member country play a role similar to that of the Fed District Banks most independent central bank in the world

Explaining Central Bank Behavior Public interest view Theory of bureaucratic behavior Is an example of principal-agent problem Bureaucracy often acts in own interest Protection of autonomy Avoid conflict with Congress and the President

Explaining Central Bank Behavior Implications for Central Banks: Act to preserve independence Try to avoid controversy: often plays games Seek additional power over banks

Should Fed be Independent? Case for Independence Independent Fed likely has longer-run objectives, politicians don't: evidence is independence produces better policy outcomes throughout the whole Avoids political business cycle Less likely deficits will be inflationary Inflationary bias due to political pressure Places monetary control under the hands of “experts” Resists pressure from Treasury Case against Independence Fed may not be accountable Hinders coordination of monetary and fiscal policy Not democratic Lack of accountability to the public History of poor performance (until recent decades)