MGT 470 Ch 9 Central Banks & the FED (me8ed) v1.0 Apr 16 1 The Functions of Central Banks The Government’s Bank:  Creates money  has a total monopoly on money creation  make a country’s money more trustworthy than money of kings, dictators and others  Controls the amount of money in circulation  this is called “monetary policy”  the amount of money in circulation dictates short-term interest rates  print and/or destroy money; this is direct control  buy or sell gov’t bonds; this is indirect control  “expansionary” or “accommodating” policy increases money supply  “tight” or “restrictive” policy decreases money supply  the unique ability of a gov’t to control money supply greatly improves its ability to control inflation  Executes financial transactions for the government  acts as the US Treasury’s bank The Banker’s Bank:  Guarantees that sound intermediaries can do business by lending to them, even in time of crisis (“lender of last resort”)  Manage the payments system for interbank payments  ensures reliability  greatly enhances funding liquidity Ch 9: Central Banks & the Federal Reserve System

MGT 470 Ch 9 Central Banks & the FED (me8ed) v1.0 Apr 16 2 The Functions of Central Banks (continued) The Banker’s Bank: (continued)  Oversees financial institutions  ensures savers & depositors can be confident in the soundness of their financial institutions  gov’t examiners & supervisors are the only ones who can be trusted to handle sensitive info without conflict of interest Objectives of Central Banks Central banks work to reduce the volatility of economic and financial systems by: 1. Maintain low and stable inflation (preserve price stability):  Volatile inflation degrades the information content of prices, (i.e. price movements caused by inflation mask price movements caused by changing supply or demand.  High inflation is detrimental to economic growth; people are reluctant to invest their money for fear of not receiving adequate compensation for inflation 2. Promote high, stable in output and employment:  The “sustainable” growth rate is one that allows an economy to grow while producing minimal negative effects  Growth lower than the sustainable rate means recession which produces higher underemployment  Growth higher than the sustainable rate means an “over heated” economy and can lead to increased inflation growth  In the long run, stability leads to higher sustainable growth rates

MGT 470 Ch 9 Central Banks & the FED (me8ed) v1.0 Apr 16 3 Objectives of Central Banks (continued) 3. Maintain financial system stability:  Minimize the occurrence of bank runs, stock market panics and other financial crisis  Primarily attempted through regulation and oversight to ensure that markets run smoothly 4. Maintain interest rate and exchange rate stability:  Stable interest rates are crucial for stable economic growth; interest rate volatility discourages investment  Stable exchange rates are crucial to doing business internationally  Since interest rates and exchange rates are greatly influenced by inflation, this task is a byproduct of Objective 1. How successful was the “Fed” in achieving these objectives since 2006? The Need for Independence of Central Banks  Successful monetary policy requires a long time horizon; longer than a term in congress  Monetary policy makers must be free to control their own budgets. If politicians can starve the central bank of funding, then they can control the bank’s decisions  The central bank’s policies must not be reversible by people outside the bank

MGT 470 Ch 9 Central Banks & the FED (me8ed) v1.0 Apr 16 4 The Central Bank of the USA is the Federal Reserve System (the “Fed”) Origins of the Federal Reserve  Fear of centralized power and distrust of moneyed interests guided central bank activities in the 19 th century  The First Bank of the U.S. was disbanded in 1811  The Second Bank of the U.S. was disbanded in 1836 when President Andrew Jackson vetoed its renewal  As a result, banking panics became regular events, absent a lender of last resort, culminating in the panic of  Widespread bank failures and depositor losses convinced the U.S. that a central bank was needed  Federal Reserve Act of 1913  fear of a “central authority” was rampant—people worried that powerful Wall Street interests would manipulate the system  questions arose as to whether such a monetary authority would be private or a government institution  the Federal Reserve Act of 1913 was a compromise that created the Federal Reserve System, including elaborate checks and balances The U.S. Federal Reserve System

MGT 470 Ch 9 Central Banks & the FED (me8ed) v1.0 Apr 16 5 Structure of the Federal Reserve System  Widespread bank failures and depositor losses convinced the U.S. that a central bank was needed  Federal Reserve Act of 1913  fear of a “central authority” was rampant—people worried that powerful Wall Street interests would manipulate the system  questions arose as to whether such a monetary authority would be private or a government institution  the Federal Reserve Act of 1913 was a compromise that created the Federal Reserve System, including elaborate checks and balances  The FRC founders decided against concentrating the federal banking system in NYC or D.C. in order to maintain public support for the idea, increasing its effectiveness  the 12 branches are spread across the country to make sure all regions of the country are represented in policy deliberations  the banks are quasi-private institutions, promoting a concern with regional issues  Design was intended to diffuse power along the following dimensions:  regions of the U.S.  government and private sector interests  needs of bankers, businesses, and the public  The system as it exists now includes:  twelve Federal Reserve Banks  Board of Governors (BOG) of the Federal Reserve System  Federal Open Market Committee (FOMC)  Federal Advisory Council  member banks (around 2,000)

MGT 470 Ch 9 Central Banks & the FED (me8ed) v1.0 Apr 16 6 Structure of the Federal Reserve System (continued)

MGT 470 Ch 9 Central Banks & the FED (me8ed) v1.0 Apr 16 7 Locations of the Federal Reserve System