1. Central Banks (in the world today) and the Federal Reserve System
Chapter 16
Central Banks (in the world today)
and the Federal Reserve System

2. Learning Objectives Functions and objectives of central banks.
Features of an effective central bank.
Federal Reserve organization and policy framework.
ECB organization and policy framework.

3. Central Banks
There are about 170 central banks in the world today. Nearly every country has one.
Interestingly, central banking is largely a 20th-century phenomenon. In 1900, only 18 countries had central banks.
When the Soviet Union collapsed in 1990, 12 of the 15 republics had central banks within a year
If we think back to Chapter 11 when we discussed moral hazard, discuss how a government ceding the right to control the amount of currency to a central bank is way to treat a potential moral hazard problem.
Answer: Government officials have a variety of options available to finance their expenditures; these include taxation, borrowing and printing money. The printing of money, though inflationary, would allow these officials to avoid the short term problems of raising taxes and or borrowing, which may reduce their chances of holding on to their office, and by printing money, the problem of inflation may not occur until they are out of office. This creates a potential moral hazard for elected officials, which is removed by giving the power to print money to an independent central bank.

4. Web Links

5. Manage the finances of the government.
Two Roles of the Central Bank The Government’s Bank , The Banker’s Bank
Government’s Bank –
Manage the finances of the government.
Control the availability of money and credit.
They create money.
Conduct monetary policy, expansionary/tight
Think back to Chapter 11 when we discussed moral hazard. Discuss how a government ceding the right to control the amount of currency to a central bank is a way to treat a potential moral hazard problem?
Answer: Government officials have a variety of options available to finance their expenditures; these include taxation, borrowing and printing money. The printing of money, though inflationary, would allow these officials to avoid the short term problems of raising taxes and or borrowing, which may reduce their chances of holding on to their office, and by printing money, the problem of inflation may not occur until they are out of office. This creates a potential moral hazard for elected officials, which is removed by giving the power to print money to an independent central bank.

6. Role of the Central Bank - The Banker’s Bank
Important day-to-day functions of the central bank
Manage the payments system (settle inter-bank payments).
Provide loans during times of financial stress (the lender of last resort credit facilities).
Oversee commercial banks and the financial system to ensure confidence in their soundness (regulatory oversight).

7. What a Central Bank is Not
In the US, the Fed does not control securities markets. It does trade in the bond market.
The Fed does not control the government’s budget.
That is determined by Congress and the president through fiscal policy.
The Fed only acts as the Treasury’s bank.

8. The Primary Objectives of all Central Banks - Stability
Low, stable inflation
High, stable growth with high employment
stable financial markets
interest rate stability
exchange rate stability
How do the specific goals of interest rate and exchange rate stability differ in importance from the other specific goals mentioned for central bankers?
Answer: As the text mentions, interest rate and exchange stability are secondary to the goals of stable growth, low inflation, and financial stability. The main reason offered is that interest and exchange rate stability are a means to obtain the other goals. While no central banker wants volatile interest rates, they often times will use the interest rate to achieve one or more of the other goals.
Provide an example where monetary policymakers in the United States would be put in a position of conflicting goals and as a result forced to make a tradeoff.
Answer: We can borrow one from the text. The economic recession that began in early 2001 and was further fueled by the terrorist acts of September 11 of that same year, saw a slowdown in the growth rate of the economy and high stable rates of growth is one of the Fed's objectives. In order to minimize the slowdown the Fed lowered the short term interest rate eleven times in just over eleven months. This conflicted with the goal of stable interest rates, and potentially with the goal of price stability. This is a situation where goals conflicted and the Fed was forces to choose one goal at the expense of the other. A tradeoff was made.

9. Should Price Stability be the Primary Goal?
The Federal Reserve has a dual mandate.
The boxed items on the previous slide
In the short run, price stability can conflict with the goal of growth and high employment.
Other countries elevate the goal of price stability
ECB has a hierarchical mandate, price stability first, then growth.
Other countries have a legislative price stability mandate – inflation targeting.

10. Why is Low and Stable Inflation Desirable?
Money ceases to function as a store of value, unit of account or medium of exchange with high inflation.

11. Zero inflation is probably too low.
How Low is Low?
No agreement on this.
Zero inflation is probably too low.
- risk of deflation which in turn results in defaults on loans and a threat to the health of banks.
- inflation measures are biased.
Countries with legislated explicit inflation targets set at 2%.
The US does not have an explicit inflation target. – but implicit at 2%.
What are the potential problems that can result if central bankers set a target of a zero rate of inflation?
Answer: A zero inflation target has a few problems. First, trying to hit a zero target risks deflation occurring. Deflation has a lot of problems including making debts more difficult to repay which can lead to an increase in loan defaults and an adverse impact on the health of banks. Deflation also increases information problems for lenders so it will be more difficult for borrowers, even creditworthy ones, to obtain loans. In addition, a zero rate of inflation would require a firm to actually cut nominal wages if it needed to reduce labor costs. If the inflation rate is positive, as long as nominal wages are constant or are increasing at a lower rate than inflation, real wages will fall. Finally, most economists agree that inflation i

12. High & Stable Real Growth
The idea is that there is some long-run normal level of production called potential output, which depends on things like
Technology,
The size of the capital stock,
The number of people who can work, and
hours worked.
Growth in these inputs leads to growth in potential output -- sustainable growth.

13. High & Stable Real Growth
The economy cycles above and below this long-run potential growth.
A role of the central bank is to change interest rates to adjust short-run cyclical growth.
In the long run, stability leads to higher growth.

14. High & Stable Real Growth
Data shows stable countries grow faster

15. US GDP Growth Rate from 1960

16. Financial System Stability
The Fed was established in 1913 to stop the financial panics that plagued the U.S. during the late 19th and early 20th centuries.
Panic of 1907

17. Interest-Rate and Exchange-Rate Stability
In the US, these goals are secondary to those of low inflation, stable growth, and financial stability.
In the hierarchy, interest-rate stability and exchange-rate stability are means for achieving the ultimate goal of stabilizing the economy.
They are not ends unto themselves.

18. Creating a Successful Central Bank
Four requirements to be successful:
independent of political pressure,
make decisions by committee,
transparent in communicating its policy actions and accountable to the public,
operate within an explicit framework that clearly states its goals and makes clear the trade-offs among them.

19. Independence
To keep inflation low, monetary decisions must be made free of political pressure.
Politicians have an incentive to create short-term prosperity (print money) at the expense of inflation tomorrow.
Central bank policy makers must think in terms of long-term inflation.
Longer time horizon needed to avoid “inflation bias”
Knowing the tendencies of politicians, governments have moved responsibility for monetary policy into a separate, largely apolitical, institution.
Most military historians will point out that successfully-waged battles and wars are often the result of having an exceptional individual in charge. At the same time, it seems that monetary policymaking seems to do well when policy is made by a committee. Contrast the two situations and discuss why a committee for monetary policymaking would be superior.
LOD: 3 Page: 389
Answer:
First of all, monetary policy is serious business but it is not war. Often times a battle requires that decisions be made quickly and there is little or no time for discussion so decisions are made by the person with the most authority and carried out. With monetary policy the time restrictions aren't so tight, and the time horizon is much longer. As a result, there is room and time for discussion. Also, the scope of the situations is different. A war or a battle has a specific scope in terms of the people immediately impacted, the causes for the battle etc. With economic matters and monetary policymaking there are many variables involved and most times not everyone is going to agree on what is wrong, what variables should be considered and what the possible remedies may be, again obtaining many viewpoints could be valuable. In the few cases discussed in the text, such as September 11th, 2001, actions by members of the Fed probably closely resembled a military response, very quick, very clear and to the point.

20. What is needed for Independence
Monetary policymakers must be free to control their own budgets.
Policies must not be reversible by people outside the central bank.
The U.S. Federal Open Market Committee’s decisions cannot be overridden by the President, Congress or the Supreme Court.

22. Decision Making by Committee
Pooling the knowledge, experience, and opinions of a group of people reduces the risk that policy will be dictated by an individual’s quirks.
Vesting so much power in one individual also poses a legitimacy problem.
Therefore, monetary policy decisions are made by committee in all major central banks in the world.

23. Accountability and Transparency
Politicians establish a set of goals.
Policymakers publicly report their progress in pursuing those goals.
Explicit goals foster accountability and disclosure requirements create transparency.
The institutional means for assuring accountability and transparency differ from one country to the next.

24. Explicit Policy Framework
Fed has a Dual Mandate – Stable prices and maximum employment.
ECB has a hierarchical mandate – inflation first, growth second.
A number of countries have explicit inflation targets set by politicians.

25. Federal Reserve System
Recognize the historical context of the development of the Federal Reserve System.
Describe the key features and functions of the Federal Reserve System.
Assess the degree of independence of the Federal Reserve.

26. Origins of the Federal Reserve System
Resistance to establishment of a central bank
Fear of centralized power
Distrust of moneyed interests
No lender of last resort
Nationwide bank panics on a regular basis
Panic of 1907 so severe that the public was convinced a central bank was needed
Federal Reserve Act of 1913
Elaborate system of checks and balances
Decentralized

27. The Structure of the Federal Reserve System
Twelve regional Federal Reserve Banks, distributed throughout the country;
Board of Governors of the Federal Reserve System, in Washington, D.C.; and
The Federal Open Market Committee.

28. The Structure of the Federal Reserve System
All national banks are required to belong to the Federal Reserve System.
State banks that receive their charters from individual state banking authorities have the option of joining, but fewer than 20% do.

29. The Federal Reserve System: The Twelve Districts

30. The 12 Federal Reserve Banks
Reserve Banks are part public and part private.
Federally chartered banks
Nonprofit - owned by the commercial banks in their districts.

31. The 12 Federal Reserve Banks
Nine directors
Six directors elected by the commercial bank members of the Reserve Bank
Three directors representing the member banks
Three representing the public.
Three directors appointed by the Boards of Governors.
Each Reserve Bank has a president who is appointed for a five-year term

32. The Federal Reserve Banks
Play an important role in formulating monetary policy:
Representation on the Federal Open Market Committee (FOMC), and
Setting the discount rate.
The New York Fed:
Executes Open market Operations.
Runs Fedwire: Interbank Funds Transfer System

33. The Board of Governors
The seven members, appointed by the president and confirmed by the U.S. Senate for 14-year terms.
The long terms are intended to foster independence by protecting the board from political pressure.
The terms are staggered limiting any individual president's influence over the membership.

34. The Board of Governors Duties of the governors are to:
Set the reserve requirement,
Approve or disapprove discount rate recommendations,
Rule-writing agency for consumer credit protection laws
(with enforcement by the Consumer Financial Protection Bureau created by the Dodd-Frank Act)
Along with the Reserve Banks, regulate and supervise the banking system,
Analyze financial and economic conditions, and
Collect and publish detailed statistics.

35. The Federal Open Market Committee
When the press discusses the Fed, its the Federal Open Market Committee (FOMC).
sets the interest rates and adjusts the Fed’s balance sheet to control the availability of money and credit to the economy.
It has existed since 1936 and has 12 voting members:
The seven governors,
The president of the Federal Reserve Bank of New York, and
A rotating selection of 4 of the remaining 11 Reserve Bank presidents.

36. The Federal Open Market Committee
The chair of the Board of Governors chairs the FOMC.
The committee’s vice chair is the president of the Federal Reserve Bank of New York.
While only 5 of the 12 Reserve Bank presidents vote at any one time, all of them participate in the meeting.

37. The Federal Open Market Committee
Controls the federal funds rate.
This is the rate banks charge each other for unsecured overnight loans on their excess deposits at the Fed.
Intent - by controlling the federal funds rate, the FOMC influences market interest rates and real economic growth.

38. The Federal Open Market Committee
The FOMC currently meets 8 times a year.
Committee can confer and change policy over the telephone.
The financial crisis of prompted 12 unscheduled FOMC meetings.
The primary purpose of a meeting is to decide on the target interest rate.
Gives directive to the system open market account manager who works for the Federal Reserve Bank of New York to carry out OMO.

39. Assessing the Federal Reserve System’s Structure
Recall, effective central bank is one in which:
Policymakers are independent of political influence,
Make decisions by committee,
Are accountable and transparent, and
State their objective(s) clearly.
Evaluate the Fed using these criteria.

40. Independence from Political Influence
Three criteria for judging central bank independence:
Budgetary independence,
Irreversible decisions, and
Long terms in office.
The Fed meets each of these.

41. The Fed controls its own budget.
Earn substantial revenue comes from interest on government securities it holds and fees charged to banks for payments system services.
Typically 95% of its income is returned to the U.S. Treasury each year.

42. Financially Independent
Earned about $113 Billion on securities.
minus interest on reserves and other expenses of $13 Billion,
Turned $100 Billion over to Treasury.
2016 and 2017, sent the Treasury $91.5 and $80.2.

43. Decision Making by Committee
The Fed clearly makes decision by committee - the FOMC
The chair of the Board of Governors may dominate policy decision, the fact that there are 12 voting member provides an important safeguard against arbitrary action.

44. Accountability and Transparency
The FOMC releases huge amount of information to the public:
Announcement of policy decision and reasoning,
Detailed minutes of the meeting 3 weeks later,
Word-for-word transcript 5 years later,
Twice-yearly “Monetary Policy Report to the Congress”,
The chair’s appearance before Congress to discuss the state of the nation’s economy, and
Numerous speeches given by the chair, other governors and Reserve Bank presidents.

45. Two Events Adding to Fed Independence:
In 1935, political appointees were removed from the Federal Reserve Board, and the FOMC was created.
In 1951, President Truman supported the Fed’s refusal to purchase Treasury securities that the Secretary of the Treasury requested they buy.
The president, the secretary of the Treasury, and the Federal Reserve chair reached an “accord” and issued a joint announcement establishing the FOMC’s independence in setting interest rates and controlling the rate of monetary expansion.

46. Fed’s Policy Framework
The Congress has set the Fed’s objectives:
“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

47. Fed’s Policy Framework
The Dual Mandate means the Fed
has instrument and goal independence
Instrument – OMO, reserve requirement,
discount rate
Dual Goals -

48. Should the Fed Be Independent?
The Case for Independence
The strongest argument for an independent central bank not influenced by political pressure which could be inflationary.
The Case Against Independence
Proponents of a Fed under the control of the president or Congress argue it is undemocratic to have monetary policy (which affects almost everyone in the economy) controlled by an elite group that is responsible to no one.
Undemocratic
Unaccountable
Can’t coordinate fiscal and monetary policy

49. European Central Bank(ECB)
European Monetary Union began January 1, 1999
Euro notes and coins began circulation January 1, 2002
19 of 28 countries in the European Union use the Euro

50. The European Central Bank
The agreement to form a European monetary union was formalized in the Treaty of Maastricht.
European Central Bank (ECB) is the institution that is responsible for monetary policy in the euro area.
The ECB and the NCBs of the 19 countries that participate in the monetary union make up what is known as the Eurosystem.
They share a common currency and common monetary policy.

51. ECB Structure
The ECB mirrors the structure of the Federal Reserve System in several ways.
A six-member Executive Board of the ECB, similar to the Board of Governors;
The National Central Banks play many of the same roles as the Federal Reserve Banks; and
The Governing Council formulates monetary policy as the FOMC does.

52. ECB Structure
The Executive Board has a president and a vice president who play the same role as the Fed’s Chair and Vice Chair.
ECB executive board members have 8 year terms and are appointed by a committee composed of the heads of state of the countries that participate in the monetary union.

53. Organizational Structure
The ECB and the NCBs together perform the traditional operational functions of a central bank.
They use interest rates to control the availability of money and credit
They are responsible for the smooth operation of the payments system and the issuance of currency.
The National Central Banks continue to serve as bankers to the banks and governments in their countries.

54. ECB Structure Monetary policy
The Governing Council is composed of the 6 Executive Board members and the governors of the 19 central banks in the euro area.
Meetings are held monthly to determine policy
Voting is on a rotating basis.

55. Organizational Structure
The Governing Council is charged with setting policy for the benefit of the euro area as a whole, regardless of economic conditions in the individual countries.
Decisions are made by formal votes of the Council, but are not published.
Ensure that Governing Council members focus on setting policy for the euro area as a whole

56. Organizational Structure
Important safeguards were included in the Treaty of Maastricht to ensure the central bank’s independence.
There are terms of office (8 year term).
The treaty states explicitly that the Governing Council cannot take instructions from any government, so its policy decisions are irreversible.

57. The Price Stability Objective and Monetary Policy Strategy
The Treaty of Maastricht states: “The primary objective of the European System of Central Banks shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community.”

58. The Price Stability Objective and Monetary Policy Strategy
The ECB’s Governing Council defines price stability as an inflation rate of close to 2 percent, based on a euro-area-wide measure of consumer prices.

59. ECB Independence Most independent in the world
Members of the Executive Board have long terms (8 years)
Determines own budget
Less goal independent compared to the Fed
Price stability is stated primary goal
Charter cannot by changed by legislation; only by revision of the Maastricht Treaty

60. Countries with Explicit Inflation Targets Bank of Canada
1934
Inflation target since 1991
Target range 1- 3 percent
Monetary Policy aimed at mid-point: 2%
Less goal independence than Fed
lation_target.html (Follow this link and read the BOC statement)

61. Bank of England
1694
Least independent up to Interest rate policy determined by chancellor of the Exchequer.
Policy now with the Bank, but can be overridden by the government.
Inflation target – 2 percent.
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