2. Federal Reserve System
Americans long resisted 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
Without lender of last resort …
Nationwide bank panics on a regular basis
Panic of 1907 … JP Morgan to the rescue?
 a central bank needed
Federal Reserve Act of 1913
Elaborate system of checks and balances
Decentralized
District banks: Quasi-public institutions owned by private member commercial banks in the district

4. } dual mandate of Fed Price stability High employment
Goals of Central Banks
Price stability
High employment
Steady growth
Financial market stability
Stable interest rates
Stable exchange rate
} dual mandate of Fed
Price stability has long-run
precedence, consistent with
high employment
Time – Inconsistency Problem: temptation to go beyond stated target
Hype the economy/lose credibility
Worker and firm altered expectations and responses undo policy intent
“Rules not discretion”
Taylor Rule: Violate it at your risk!
But… Governor Mishkin’s pragmatism
Bagehot’s rule: Lend and lend freely
Keynes: In the long-run we’re all dead

5. Time Inconsistency: An Example

6. The Functions of a Modern Central Bank
The Government's Bank:
Manages government transactions.
Controls availability of money and credit.
The Banker’s Bank:
Lender of last resort in crises
Operates clearing system for interbank payments.
Oversees financial intermediaries
- ensure their soundness.
- ensure public confidence

7. Functions of Federal Reserve District Banks
Clear checks
Issue new currency/withdraw damaged currency
Make discount loans to banks in district
Evaluate mergers/expansions of bank activities
Liaison between business community and the Fed
Examine bank holding companies and state-chartered member banks
Collect data on local business conditions
Research Money, Banking and the Financial System
FRBNY’s special roles
Bond and currency open market operations
Supervise bank holding companies in NY district
Member of Bank for International Settlements

8. Direct open market operations
Board of Governors
Seven members headquartered in D.C.
Appointed by president/confirmed by Senate
14-year non-renewable term
Chairman serves 4-year renewable term
Chairman speaks for Fed/“Runs the Show”
Set reserve requirements
Control the discount rate
Direct open market operations
Approve bank mergers
Regulate bank holding companies/foreign banks in the US

9. Federal Open Market Committee(FOMC)
Meets eight times a year … more often if needed
Reports on domestic and currency open market operations
“Green book” forecast
“Blue book” forecasts … responses to alternative policies
12 Voting members: 7 Fed Governors; president of FRBNY; and presidents of 4 other district banks in rotation
BoG Chairman chairs FOMC
End of meeting announcements:
Directive to the trading desk at FRBNY
Balance of risks statement

10. …small events at times have large consequences
…small events at times have large consequences. A liquidity crisis in a fractional reserve banking system is precisely the kind of event that can trigger – and often has triggered – a chain reaction. And economic collapse often has the character of a cumulative process. Let it go beyond a certain point, and it will tend for a time to gain strength from its own development as its effects spread and return to intensify the process of collapse. Because no great strength would be required to hold back the rock that starts a landslide, it does not follow that the landslide will not be of major proportions.
Friedman and Schwartz
A Monetary History of the United States

11. How Independent is the Fed?
Instrument independent
Goal independent … undemocratic?
Political pressure would impart inflationary bias to monetary policy
Political business cycle?
Could facilitate Treasury financing of large budget deficits—accommodation
Independent revenue
Structured by Congress/accountable to Congress
Presidential influence
Influence on Congress
Appoints members
Appoints chairman

12. European Central Bank Patterned after the Federal Reserve
Central banks from each country play similar role as Fed district banks
Monetary operations are not centralized
ECB does not supervise and regulate financial institutions
More independent than Fed
Maastricht Treaty would have to be revised to change ECB charge
But less goal independent than Fed
Price Stability Rules