978-0132994910 Chapter 13 Lecture Note

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Chapter 13

The Federal Reserve and Central Banking

Brief Chapter Summary and Learning Objectives

13.1 The Structure of the Federal Reserve System (pages 388–399)

Explain why the Federal Reserve is structured the way it is.

The Federal Reserve Act established the Federal Reserve System as the central bank of the

United States in 1913.

As part of its plan to decentralize authority within the Federal Reserve System, Congress divided

the United States into 12 Federal Reserve districts, each of which has a Federal Reserve Bank

that carries out duties related to the Fed’s roles in the payments system, control of the money

supply, and financial regulation.

The president appoints and the Senate confirms the Board of Governors. This board administers

monetary policy and is also responsible for some financial regulation.

The 12-member Federal Open Market Committee (FOMC) oversees the Fed’s open market

operations.

Though the Board of Governors and the FOMC exert most of the Fed’s formal influence on

monetary policy, many Fed watchers believe that the informal authority of the chairman, the

staff of the board, and the FOMC predominates.

13.2 How the Fed Operates (pages 399–406)

Explain the key issues involved in the Fed’s operations

Congress intended the Federal Reserve System to operate largely independently of external

pressures from the president, Congress, the banking industry, and business groups.

Some policymakers and economists debate the arguments in favor of central bank independence.

13.3 Central Bank Independence Outside the United States (pages 406–409)

Discuss the issues involved with central bank independence outside the United States.

Though central bank independence from the political process has increased around the world, in

practice, the degree of actual independence in the conduct of monetary policy varies across

countries.

In principle, the European Central Bank (ECB) has a high degree of overall independence, with

a clear mandate to emphasize price stability, and is free from interference by the European

Union or national governments in the conduct of policy.

Key Terms

Board of Governors The governing board of the

Federal Reserve System, consisting of seven

members appointed by the president of the

United States.

Federal Reserve System The central bank of the

United States.

Political business cycle The theory that

policymakers will urge the Fed to lower interest

Wall Street Reform and Consumer Protection

Act (Dodd-Frank Act) Legislation passed

during 2010 that was intended to reform

regulation of the financial system.

Federal Open Market Committee (FOMC)

The 12-member Federal Reserve committee that

directs open market operations.

Federal Reserve Bank A district bank of the

Federal Reserve system that, among other

activities, conducts discount lending.

rates to stimulate the economy prior to an election.

Principal–agent view A theory of central bank

decision making that holds that officials maximize

their personal well-being rather than that of the

general public.

Public interest view A theory of central bank

decision making that holds that officials act in the

best interest of the public.

Wall Street Reform and Consumer Protection

Act (Dodd-Frank Act) Legislation passed

during 2010 that was intended to reform

regulation of the financial system.

Chapter Outline

Teaching Tips

This chapter highlights the difference between the high degree of decentralization of the Federal

Reserve that exists on paper the high degree of centralization that exists in practice. The chapter

also discusses the public-interest view of Fed motivation—which holds that the Fed acts in the

interests of the general public—and the principal-agent view—which holds that the Fed acts to

increase its power, influence, and prestige as an organization, subject to constraints placed on it

by the president and Congress. The chapter also presents the arguments for and against the Fed

remaining independent of Congress and the president. Central bank independence in other

countries is also discussed. The chapter concludes with a section on the European Central Bank

and the sovereign debt crisis.

Has the Fed Become Too Powerful?

Some members of Congress have criticized the Fed’s policy actions during the 2007-2009 financial crisis

and have proposed reducing the Fed’s autonomy. Although the Fed’s financial statements have been

audited since 1978, the Dodd-Frank Wall Street Reform and Consumer Protector Act of 2010 authorized

an audit of the emergency lending practices of the Fed during the financial crisis. In 2012, the House of

Representatives authorized the General Accounting Office to audit the monetary policy actions of the Fed.

Many economists and Fed Chair Ben Bernanke saw this action as an attempt to reduce the independence

of the Fed. Ultimately, the Senate did not approve the bill so it did not become law. Still, some critics

continue to argue that the Fed has assumed too important a role in the economy.

13.1 The Structure of the Federal Reserve System (pages 388–399)

Learning Objective: Explain why the Federal Reserve is structured the way it is.

A. Creation of the Federal Reserve System

The Federal Reserve Act established the Federal Reserve System as the central bank of the United

States in 1913. The act and subsequent legislation created four groups within the system, each

empowered, in theory, to perform separate duties:

1. The Federal Reserve Banks

2. Private commercial member banks

3. The Board of Governors

4. The Federal Open Market Committee (FOMC)

B. Federal Reserve Banks

As part of its plan to decentralize authority within the Federal Reserve System, Congress

divided the United States into 12 Federal Reserve districts, each of which has a Federal Reserve

Bank in one city (and, in most cases, additional branches in other cities in the district). See

Figure 13.1 on page 390 of the text for a map of the Federal Reserve System. The 12 Federal

Reserve District Banks carry out duties related to the Fed’s roles in the payments system,

control of the money supply, and financial regulation.

C. Member Banks

Although the Federal Reserve Act required all national banks to become member banks of the

Federal Reserve System, state banks were given the option to join, and many chose not to.

Currently, only about 16% of state banks are members.

D. Board of Governors

The Board of Governors has seven members that are appointed by the President of the United

States and confirmed by the U.S. Senate. To provide for central bank independence, the terms

of board members are set so that governors serve nonrenewable terms of 14 years, which are

staggered. The president chooses one member of the Board of Governors to serve as chairman

for a four-year term that can be renewed. The Board of Governors administers monetary policy

to influence the nation’s money supply and interest rates through open market operations, reserve

requirements, and discount lending, and is also responsible for some financial regulation.

E. The Federal Open Market Committee

The 12-member Federal Open Market Committee (FOMC) oversees the Fed’s open market

operations. Voting members of the FOMC are:

The chairman of the Board of Governors

The other Fed governors

The president of the Federal Reserve Bank of New York

The presidents of 4 of the other 11 Federal Reserve Banks (who serve rotating one-year

terms)

Teaching Tips

Ask students to read the latest monetary policy statement released by the Federal Reserve. The statements

are available on the Board of Governors’ Web site:

http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm. Have students consider how the

statement reflects the FOMC’s views on the economy and how it provides a justification for its monetary

policy decision. Ask them whether the statement is written clearly enough that they were able to

understand what the FOMC intends to do and why they intend to do it.

F. Power and Authority within the Fed

Banking legislation during the 1930s gave the Board of Governors the authority to set reserve

requirements and the FOMC the authority to conduct open market operations, while also giving

the Board of Governors a majority on the FOMC. Although the Board of Governors and the

FOMC have formal control over monetary policy, many Fed watchers believe that the informal

authority of the chairman, the staff of the board, and the FOMC predominates.

G. Changes to the Fed under the Dodd-Frank Act

When the Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) passed in

July 2010, its changes to the Fed were relatively minor. Among the changes the Dodd-Frank

Act authorized are:

The Fed was made a member of the new Financial Stability Oversight Council and the new

Consumer Financial Protection Bureau (CFPB) is housed at the Fed, although the Fed was

given no managerial oversight of the CFPB.

The Government Accountability Office (GAO) was authorized to conduct an audit of the

emergency lending programs undertaken by the Fed during the crisis, and

The Fed was ordered to release the names of financial institutions it makes loans to and buys

and sells securities from.

13.2 How the Fed Operates (pages 399–406)

Learning Objective: Explain the key issues involved in the Fed’s operations.

A. Handling External Pressure

Congress intended the Federal Reserve System to operate largely independently of external

pressures from the president, Congress, the banking industry, and business groups. The Fed’s

financial independence allows it to resist external pressure. Despite the attempt to give the Fed

independence, it isn’t completely insulated from external pressure. First, the president can

exercise control over the membership of the Board of Governors. Second, although the Fed’s

earnings on its holdings of bonds and other securities exempt it from requesting money from

Congress, the Fed remains a creation of Congress.

B. Examples of Conflict between the Fed and the Treasury

During Word War II, the Fed agreed to hold interest rates on Treasury securities at low levels to

help finance wartime budget deficits. On March 4, 1951, the wartime policy of fixing the

interest rates on Treasury securities was abandoned with the Treasury–Federal Reserve Accord,

which re-established the ability of the Fed to operate independently of the Treasury. During the

financial crisis of 2007–2009, the Fed worked closely with the Treasury, raising concern among

some that the Fed was sacrificing some of its independence.

C. Factors That Motivate the Fed

The public interest view of Fed motivation holds that the Fed acts in the interest of its primary

constituency (the general public) and that it seeks to achieve economic goals that are in the

public interest. Proponents of the principal–agent view argue that the Fed avoids conflicts with

groups that could limit its power, influence, and prestige. One implication of this view is the

possibility of a political business cycle in which the Fed would lower interest rates to stimulate

economic activity before an election to earn favor with the incumbent party running for

reelection. The facts for the United States don’t generally support the idea of a political

business cycle.

D. Fed Independence

The main argument for Fed independence is that monetary policy—which affects inflation,

interest rates, exchange rates, and economic growth—is too important and technical to be

determined by politicians, who may be concerned with short-term benefits and disregard

long-term costs. Another argument for Fed independence is that complete control of the Fed by

elected officials increases the likelihood of a political business cycle. Opponents of the Fed’s

independence claim that in a democracy, elected officials should make public policy because

they can be held responsible by the voters. Those who argue for greater Congressional control

of monetary policy argue that the Fed has not always used its independence well.

13.3 Central Bank Independence Outside the United States (pages 406–409)

Learning Objective: Discuss the issues involved with central bank independence outside the

United States.

In practice, the degree of central bank independence in the conduct of monetary policy varies

across countries. Many analysts believe that an independent central bank improves an economy’s

performance by lowering inflation without increasing fluctuations in output or employment. For

independence to be meaningful, the central bank must be able to conduct policy without direct

interference from the government. The central bank also must be able to set goals for which it can

be held accountable.

A. The European Central Bank

In principle, the European Central Bank (ECB) has a high degree of overall independence, with

a clear mandate to emphasize price stability, and it is free to conduct policy without

interference from the European Union or from national governments.

Teaching Tips

Ask students to consider the pros and cons regarding the independence of the Fed. Have them consider

why the global trend has been to increase the independence of central banks. A useful classroom

experience is to have a brief—10 to 15 minute—debate between two groups of students; one group

arguing to preserve the Fed’s independence as it now is and the other group arguing that Congress and the

president should exert greater control over monetary policy.

B. The European Central Bank and the Sovereign Debt Crisis

The European Central Bank (ECB) has a more complex mission than the Fed because it is responsible for

the monetary policy of the 17 sovereign countries that use the euro as currency. In 2010, several countries within the

euro area experienced a sovereign debt crisis. The ECB debated whether to intervene by purchasing some of the debt

but had concerns that doing so may raise expectations of inflation and give approval to poor budgetary practices of

some governments. In May 2010, ECB President Jean-Claude Trichet began buying sovereign debt. The program

was expanded through 2012 by the new ECB President, Mario Draghi in an attempt to contain the sovereign debt

crisis and stabilize the European banking system