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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
