Get documents about "Chapter 16 The Structure of Central BanksThe Federal Reserve
Document Sample
ECON 333 L1
Week 5, T4, Fall 2009
Chapter 16 The Structure of Central Banks:The Federal Reserve and the European
Central Bank
I. The Structure of the Federal Reserve System
1. The Federal Reserve Act, passed in 1913 and amended several times since
then, establishes a system that is composed of three branches with
overlapping responsibilities.
2. There is are the twelve regional Federal Reserve Banks, distributed
throughout the country; a central governmental agency, the Board of
Governors, located in Washington, D.C.; and the Federal Open Market
Committee.
3. In addition, a series of advisory committees makes recommendations to the
Board and the regional Banks.
4. Finally, there are the commercial banks that are members of the system.
5. This complex structure diffuses power in a way that is typical of the U.S.
government, creating a system of checks and balances that reduces the
tendency for power to concentrate at the center.
6. All national banks (chartered by the federal government) are required to
belong to the Federal Reserve System, and state banks have the option to join
(though less than 20 percent do because of the cost involved).
7. Members and nonmembers alike must hold non-interest bearing reserve
deposits at the Fed, so there is no real distinction between them.
A. The Federal Reserve Banks
1. The Federal Reserve Bank of New York is the largest of the twelve regional
Federal Reserve Banks.
2. The geographical lines that define the Banks’ districts were drawn in 1914 and
represent the population density at the time and the decision that no district
should coincide with a single state.
3. This arrangement has two purposes: to ensure that every district contains as
broad a mixture of economic interests as possible and that no person or group
can obtain preferential treatment from the Reserve Bank.
4. Reserve Banks are part public and part private; they are owned by the
commercial banks in their districts and are overseen by the Board of
Governors.
5. The Board of Directors of each bank is comprised of representatives of
banking, other business leaders, and those who represent the public interest.
1
Of the nine members on each board, six are elected by the commercial bank
members and three are appointed by the Board of Governors.
6. Each Reserve Bank has a President who is appointed for a five-year term by
the Bank’s Board of Directors (with the approval of the Board of Governors).
7. The Reserve Banks conduct the day-to-day business of the central bank,
serving as both the government’s bank and the bankers’ bank.
8. As the bank for the U.S. government they issue new currency, maintain the
U.S. Treasury’s bank account, and manage the U.S. Treasury’s borrowings.
9. As the bankers’ bank they hold deposits for the banks in their districts, operate
and ensure the integrity of a payments network, make funds available to
commercial banks in the district through “discount loans,” supervise and
regulate financial institutions in the district, and collect and make data
available on business conditions.
10. In addition to these duties the Federal Reserve Bank of New York provides
services to foreign central banks and to certain international organizations that
hold accounts there; it is also the System’s point of contact with financial
markets.
11. Finally, the Reserve Banks play an important part in formulating monetary
policy, both through their responsibilities on the FOMC and through their
participation in setting the discount rate.
B. The Board of Governors
1. The seven members of the Board are appointed by the President and
confirmed by the U.S. Senate for 14-year terms, which are staggered (typically
one new member is appointed every two years).
2. These long terms are intended to protect the Board from political pressure, as
is the fact that the terms are staggered so that one begins every two years.
3. The Board has a Chairman and a Vice Chairman, appointed by the President
from among the seven governors for four-year renewable terms.
4. The duties of the Board are to: set the reserve requirement, approve or
disapprove the discount rate recommendations made by the Federal Reserve
Banks, administer consumer credit protection laws, approve bank mergers,
supervise and regulate the regional Reserve Banks, regulate and supervise
the banking system (along with the Reserve Banks), analyze financial and
economic conditions, and collect and publish statistics about the system’s
activities and the economy at large.
C. The Federal Open Market Committee
1. The FOMC is the group that sets interest rates to control the availability of
money and credit to the economy.
2
2. Made up of the seven Governors, the President of the NY Fed, and four
Reserve Bank Presidents, it is chaired by the Chairman of the Board of
Governors.
3. The FOMC controls the federal funds rate, the rate banks charge each other
on overnight loans of excess deposits at the Fed.
4. The FOMC meets eight times a year, although in extraordinary times it can
meet more often.
5. The primary purpose of a meeting is to decide on the target interest rate and
produce a policy directive, which tells the NY Fed how to conduct purchases
and sales of Treasury securities in order to meet the FOMC’s goals.
6. Prior to each meeting participants receive the beige book (a compilation of
anecdotal information about current business activity), the green book (the
Board staff’s economic forecast for the next few years) and the blue book (a
discussion of financial markets and current policy options).
7. An FOMC meeting is a formal proceeding that can be divided into three parts:
reports by the staff, and two rounds of discussion by the meeting participants.
8. Reports by the staff include presentations by the System Open Market
Account Manager (reporting on financial market conditions and actions taken
to maintain the target interest rate since the last meeting); the Director of the
Division of International Finance (commenting on recent international
economic developments); and the Director of the Division of Research and
Statistics at the Federal Reserve Board (presenting the staff’s forecast from
the green book).
9. The ensuing round of discussion is called the economic go-round. One at a
time committee members describe their view of the economic outlook, and
then the Chair speaks at the end.
10. Next, the Director of Monetary Affairs describes the policy options (from the
blue book). Committee members again comment on the options, with the
Chair speaking last.
11. Finally there is a vote taken, with the Chair voting first, the Vice Chair second,
and then the committee members (in alphabetical order).
12. The Chair of the Federal Reserve is the FOMC’s most powerful member; to
have an impact on policy, governors or Reserve Bank presidents must build
support for their positions through their statements at the meeting and in public
speeches.
13. However, while the Chair is very powerful, the committee structure does
provide an important check on that person’s power.
3
II. Assessing the Federal Reserve System’s Structure
A. Independence from Political Influence
1. The Fed controls its own budget, which is an important criterion for central
bank independence.
2. The Fed does occasionally come under political attack, especially when it
believes it must raise interest rates.
B. Decision Making by Committee
1. The Fed meets this criterion for independence because the FOMC is a
committee.
2. The chair may dominate policy decisions, but the fact that there are 12 voting
members provides an important safeguard against arbitrary action by a single
individual.
C. Accountability and Transparency
1. The FOMC releases huge amounts of information to the public.
2. However, there is no regular press conference or real questioning of the chair
on the FOMC’s current policy stance.
3. Moreover, some information is released well after the fact of the meeting.
4. Also, the Committee’s refusal to state its objectives clearly and concisely
hampers communication.
D. Policy Framework
1. The Congress of the United States has set the Fed’s objectives, but the
statement is vague enough that the Fed can essentially set its own goals.
2. Many people have argued that the system should be replaced by one in which
the FOMC’s objectives are made clear and the Committee announce a
specific numerical objective for consumer price inflation over some horizon.
III. The European Central Bank
A. Organizational Structure
1. The Eurosystem mirrors the structure of the Federal Reserve in that there is
an Executive Board (like the Board of Governors), the National Central Banks
(like the regional Federal Reserve Banks) and the Governing Council (which,
like the FOMC, formulates monetary policy).
2. The Executive Board has a President and Vice President who play the same
role as the Chairman and Vice Chairman of the Fed.
3. 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
4
and credit in the economy, are responsible for the smooth operation of the
payments system, and issue currency.
4. The NCBs continue to serve as bankers to the banks and governments in their
countries.
5. Unlike the Fed, the ECB does not supervise and regulate financial institutions.
Also, the implementation of monetary policy is not centralized and the ECB’s
budget is controlled by the NCBs and not vice versa.
6. The focus of the ECB’s activity is on the control of money and credit in the
Eurosystem.
7. The Governing Council meets monthly and decisions are made by consensus;
no formal votes are taken, because votes may get in the way of good policy.
8. The ECB’s independence is protected by long terms of office, the fact that the
ECB’s financial interest must remain separate from any policy organization,
and by the provision in the Treaty of Masstricht that the Governing Council
cannot take instructions from any government.
9. As the number of members in the Eurosystem has increased, the Governing
Council has adopted a rotating system for voting like that used by the FOMC.
B. Accountability and Transparency
1. The most important aspect of the ECB’s communication strategy concerns
statements about the Governing Council’s policy deliberations; unlike the
FOMC there is a news conference at which questions are taken and the
transcript is posted on the website immediately.
2. The primary problem with ECB communications is that there often are a
number of conflicting opinions expressed.
3. But indications are that the system is working and that there is accountability.
C. The Price Stability Objective and Monetary Policy Strategy
1. The Treaty of Maastricht states that the primary objective of the ECB is to
maintain price stability.
2. The ECB’s strategy has been to numerically define price stability and to focus
on a broad-based assessment of the outlook for future prices, with money
playing a prominent role.
3. Price stability is defined as inflation of close to 2 percent, based on a
euro-area wide measure of consumer prices called the Harmonized Index of
Consumer Prices (similar to the U.S. CPI).
4. The economically large countries matter much more than the small ones,
which affects the dynamics of the Governing Council’s policy making.
5. However, evidence suggests that the ECB is doing the job it is supposed to do.
5
Conceptual Problems
1. What are the Federal Reserve’s goals? How are Fed officials held accountable for
meeting them?
Answer: The goals of the Federal Reserve, as set by Congress are to “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." The
Fed’s officials release large amounts of information in order to maintain accountability.
After each of the meetings of the FOMC, the target interest rate is released
immediately, along with a brief statement. Minutes and transcripts of the meetings
are also eventually made public. Members of the FOMC give public speeches and
the chair reports to Congress and twice a year.
3. Some people have argued that the high inflation of the late 1970s was a
consequence of the fact that Federal Reserve Board Chairman Arthur Burns did what
President Richard Nixon wanted him to do. Explain the connection.
Answer: Because politicians are elected for relatively short terms, they favor
expansionary monetary policy that will boost growth in the short run. However, this
will eventually lead to higher inflation. This is why it is important for the central bank
to be independent.
4. *How did the political climate in the early 1900’s influence the structure of the
Federal Reserve System?
Answer: The reluctance to centralize power is evident in the complex structure of
the Federal Reserve System. The combination of the Board of Governors in
Washington D.C. and the Federal Reserve Banks serving various districts diffuses
power away from the center and creates a system of checks and balances.
5. While the Chair of the Federal Reserve Board has only one of 12 votes on the
FOMC, he is never in the minority. What gives him the power to control the
Committee?
Answer: The Chair controls the staff of the Board of Governors that produces the
material distributed to the Committee members prior to the meeting; he controls the
agenda of the meeting; he controls when people speak; and he is the first to make a
policy recommendation.
6. What are the goals of the ECB? How are its officials held accountable for
meeting them?
Answer: The primary goal of the ECB is to maintain price stability, which the ECB
defines as inflation of less than, but close to, two percent using the Harmonized Index
of Consumer Prices. Like the Federal Reserve, the ECB is held accountable
through releases of information, including the target interest rate along with an
6
explanatory statement, reports to the European Parliament, and public speeches.
8. Do you think the FOMC has an easier or a harder time agreeing on monetary
policy than the Governing Council of the ECB? Why?
Answer: The presence of national biases is likely to make agreement among
members of the Governing Council of the ECB more difficult. By contrast, the
Federal Reserve has very little regional bias. Also, a group of 12 (the number of
voting FOMC members) is likely to have an easier time coming to a decision than a
group of 18 (the current number of ECB Governing Council members).
9. *What are the two most important factors in ensuring that power is
decentralized in the Eurosystem?
Answer: The ECB’s budget is controlled by the national central banks and the
executive board members are always a minority on the Governing Council.
7
Chapter 17 The Central Bank Balance Sheet and the Money Supply Process
I. The Central Bank’s Balance Sheet
1. The central bank engages in numerous financial transactions, all of which
cause changes in its balance sheet.
2. Central banks publish their balance sheets regularly; the Fed and the ECB do
so weekly. Publication is a crucial part of transparency.
A. Assets
1. The central bank’s balance sheet shows three basic assets: securities, foreign
exchange reserves, and loans.
2. Securities: the primary assets of most central banks; independent central banks
determine the quantity of securities that they purchase. For the U.S. Federal
Reserve, these are primarily U.S. Treasury securities.
3. Foreign Exchange Reserves: the central bank’s and government’s balances of
foreign currency and are held as bonds issued by foreign governments. These
reserves are used in foreign exchange market interventions.
4. Loans are extended to commercial banks. There are several kinds. Discount
loans are the loans the Fed makes when commercial banks need short-term
cash.
5. Through its holdings of U.S. Treasury securities the Fed controls the federal funds
rate and the availability of money and credit.
B. Liabilities
1. There are three major liabilities: currency, the government’s deposit account,
and the deposit accounts of the commercial banks.
2. The first two items represent the central bank in its role as the government’s bank,
and the third shows it as the bankers’ bank.
3. Currency: nearly all central banks have a monopoly on the issuance of currency,
and currency is the principal liability of the Fed.
4. Government’s account: the central bank provides the government with an
account into which it deposits funds (primarily tax revenues) and from which it
writes checks and makes electronic payments.
5. Reserves: Commercial bank reserves consist of cash in the bank’s own vault
and deposits at the Fed, which function like the commercial bank’s checking
account.
6. Central banks run their monetary policy operations through changes in banking
system reserves.
8
C. The Importance of Disclosure
1. The balance sheet published by the central bank is probably the most
important information that it makes public; it is an essential aspect of central
bank transparency.
D. The Monetary Base
1. Currency in the hands of the public and the reserves of the banking system
are the two components of the monetary base, also called high-powered
money.
2. The central bank can control the size of the monetary base and therefore the
quantity of money.
II. Changing the Size and Composition of the Balance Sheet
The central bank controls the size of its balance sheet. Policymakers can enlarge
or reduce their assets and liabilities at will.
The central bank can buy things, like a bond, and create liabilities to pay for them.
It can increase the size of its balance sheet as much as it wants.
There are four specific types of transactions which can affect the balance sheets
of both the central bank and the banking system: (1) an open market
operation, in which the central bank buys or sells a security; (2) a foreign
exchange intervention, in which the central bank buys or sells foreign currency
reserves; (3) the central bank’s extension of a discount loan to a commercial
bank; and (4) the decision by an individual to withdraw cash from a bank.
Open market operations, foreign exchange interventions, and discount loans all
affect the size of the central bank’s balance sheet and they change the size of
the monetary base; cash withdrawals by the public create shifts among the
different components of the monetary base, changing the composition of the
central bank’s balance sheet but leaving its size unaffected.
One simple rule will help in understanding the impact of each of these four
transactions on the central bank’s balance sheet: When the value of an asset
on the balance sheet increases, either the value of another asset decreases
(so that the net change is zero) or the value of a liability rises by the same
amount (and similarly for an increase in liabilities).
A. Open Market Operations
1. OMO is when the Fed buys or sells securities in financial markets.
2. These purchases and sales have a straightforward impact on the Fed’s
balance sheet: its assets and liabilities increase by the amount of a purchase,
and the monetary base increases by the same amount.
9
3. In terms of the banking system’s balance sheet, the purchase has no effect on
the liabilities, and results in two counterbalancing changes on the asset side,
so the net effect there is zero.
4. For an open market sale the effects would be the same but in the opposite
direction.
B. Foreign Exchange Intervention
1. The impact of a foreign exchange purchase is almost identical to that of an
open market purchase: the Fed’s assets and liabilities increase by the same
amount, as does the monetary base.
2. If the Fed buys from a commercial bank, the impact again is like the open
market purchase, except the assets involved are different.
C. Discount Loans
1. The Fed does not force commercial banks to borrow money; the banks ask for
loans and must provide collateral, usually a U.S. Treasury bond.
2. When the Fed makes a loan it creates an asset and a matching increase in its
reserve liabilities.
3. The extension of credit to the banking system raises the level of reserves and
expands the monetary base.
4. The banking system balance sheet shows an increase in assets (reserves)
and an increase in liabilities (the loan).
D. Cash Withdrawal
1. Cash withdrawals affect only the composition, not the size, of the monetary
base.
2. When people withdraw cash they force a shift from reserves to currency on the
Fed’s balance sheet.
3. The withdrawal reduces the banking system’s reserves, which is a decrease in
its assets, and if the funds come from a checking account, there is a matching
decrease in liabilities.
4. On the Fed’s balance sheet both currency and reserves are liabilities, so there
is just a change between the two with a net effect of zero.
III. The Deposit Expansion Multiplier
A. Deposit Creation in a Single Bank
1. If the Fed buys a security from a bank, the bank has excess reserves, which it
will seek to lend.
2. The loan replaces the securities as an asset on the bank’s balance sheet.
10
B. Deposit Expansion in a System of Banks
1. However, the loan that the bank made was spent and as the checks cleared,
reserves were transferred to other banks.
2. The banks that receive the reserves will seek to lend their excess reserves,
and the process continues until all of the funds have ended up in required
reserves.
3. Assuming no excess reserves are held and that there are no changes in the
amount of currency held by the public, the change in deposits will be the
inverse of the required deposit reserve ratio (rD) times the change in required
reserves, or ∆D = (1/rD) ∆RR
4. The term (1/rD) represents the simple deposit expansion multiplier.
5. A decrease in reserves will generate a deposit contraction in a multiple amount
too.
IV. The Monetary Base and the Money Supply
Deposit Expansion with Excess Reserves and Cash Withdrawals
The simple deposit expansion multiplier was derived assuming no excess
reserves are held and that there is no change in currency holdings by the
public. These assumptions are now relaxed.
The desire of banks to hold excess reserves and the desire of account holders to
withdraw cash both reduce the impact of a given change in reserves on the
total deposits in the system; the two factors operate in the same way as an
increase in the reserve requirement.
The Arithmetic of the Money Multiplier
1. The amount of excess reserves a bank holds depends on the costs and
benefits of holding them, where the cost is the interest foregone and the
benefit is the safety from having the reserves in case there is an increase in
withdrawals.
2. The higher the interest rate, the lower banks’ excess reserves will be; the
greater the concern over possible deposit withdrawals, the higher the excess
reserves will be.
3. Similarly, the decision of how much currency to hold depends on the costs and
benefits, where the cost is the interest foregone and the benefit is the lower
risk and greater liquidity of currency.
4. As interest rates rise cash becomes less desirable, but if the riskiness of
alternative holdings rises or liquidity falls, then it becomes more desirable.
5. Deriving the money multiplier tells us that the quantity of money in the
economy depends on the monetary base, the reserve requirement, the desire
by banks to hold excess reserve and the desire by the public to hold currency.
11
6. The quantity of money changes directly with the base, and for a given amount
of the base, an increase in either the reserve requirement or the holdings of
excess reserves will decrease the quantity of money.
7. But currency holdings affect both the numerator and the denominator of the
multiplier, so the effect is not immediately obvious. Logic tells us that an
increase in currency decreases reserves and so decreases the money supply.
The Limits of the Central Bank’s Ability to Control the Quantity of Money
1. There is no tight link between the monetary base and the quantity of money.
2. In places like the United States, Europe, and Japan, the link between the
central bank’s balance sheet and the quantity of money circulating in the
economy has become too weak and unpredictable to be exploited for policy
purposes.
3. The problem is that the money multiplier is too variable.
4. Therefore, modern central banks keep an eye on trends in money growth
since that is what ultimately determines inflation. For short-run policy, interest
rates have become the monetary policy tool of choice.
Conceptual Problems
1. Follow the impact of a $100 cash withdrawal through the entire banking system,
assuming that the reserve requirement is 10 percent and that banks have no
desire to hold excess reserves.
Answer: Deposits fall by $100 and reserves fall by $100. The bank (Bank A) needs
to increase its reserves by $90 in order to meet the required reserve ratio. To raise
the $90, Bank A will sell $90 of securities to someone. The deposit account of the
person who purchased the securities will fall by $90, as will the reserve balance of his
bank, Bank B. Bank B now needs to increase its reserves by $81 in order to meet
the reserve requirements so it will sell $81 of securities. This continues until
deposits contract by $100/0.1 = $1000.
2. Compute the impact on the money multiplier of an increase in desired currency
holdings from 10 percent to 15 percent of deposits when the reserve requirement
is 10 percent of deposits, and banks’ desired excess reserves are 3 percent of
deposits.
Answer:
1 + 1.1
When desired currency holdings = 10% of deposits, m = = 1.71
1.1 + 0.1 + 0.03
1 + 1.15
When desired currency holdings = 15% of deposits, m = = 1.68
1.15 + 0.1 + 0.03
12
3. Consider an open market purchase by the Fed of $3 billion of Treasury bonds.
Show the impact of the purchase on the bank from which the Fed bought the
securities. Then, using the assumptions in problem 2, compute the impact on
M1.
Answer: The bank’s securities fall by $3 billion and reserves rise by $3 billion.
Assuming that the required reserve ratio is 10 percent, the bank does not want to
hold extra reserves, and the public does not wish to hold currency, the value of
deposits will rise by $30 billion.
4. *Why is currency circulating in the hands of the nonbank public considered a
liability of the central bank?
Answer: Currency issued by the central bank is effectively an IOU to the holder of the
currency. The central bank is obliged to pay back the holder of the currency. If the
currency is backed by gold, for example, the central bank is obliged to exchange gold
for currency. With fiat money, however, the central bank is obliged only to exchange
currency for more currency.
5. The U.S. Treasury maintains accounts at commercial banks. What would be the
consequences if the Treasury shifted funds from one of those banks to the Fed?
Answer: The balance sheet for the bank would reflect a decrease in reserves and a
decrease in deposits. The decrease in reserves would also appear on the Fed’s
balance sheet; however, it would be balanced by an increase in the government’s
account. The consequences would be a decline in the quantity of money.
6. In an effort to diversify, the Central Bank of China has decided to exchange some
of its dollar reserves for euros. Follow the impact of this move on the U.S.
banking system's balance sheet, the Federal Reserve's balance sheet, and the
European Central Bank’s balance sheet. What is the impact on the U.S. and
Chinese monetary bases?
Answer: The decision by a foreign central bank to sell dollars moves the dollars into
the U.S. commercial banking system, increasing U.S. commercial bank reserves and
thus the U.S. monetary base. The balances sheets of the various central banks are
unaffected, as is the Chinese monetary base.
7. Suppose the Fed buys $1 billion in Japanese yen, paying in dollars. What is the
impact on the monetary base? What would the Fed need to do to keep the
monetary base from changing following the purchase?
Answer: On the Fed’s balance sheet, currency and foreign reserves would both rise
by $1 billion; the monetary base would increase by $1 billion. If the Fed wished to
13
keep its balance sheet from changing (performing what is called a “sterilized
intervention”) it could then sell $1 billion in securities.
8. List the factors that you suspect may have caused the Federal Reserve to lose
control of the quantity of money in the economy. Explain your reasoning.
Answer: Financial and technological innovations have had an impact on the various
components of the money multiplier. The increasing variability and unpredictability of
the money multiplier has weakened the link between the monetary base and the
money supply. Some factors that have contributed to the changing value of the
money multiplier include the introduction of ATM machines, rising use of credit cards,
and increased availability of relatively liquid financial instruments, such as money
market mutual funds; all of these have reduced the currency-to-deposit ratio. The
practice of “sweeping” balances from checking accounts into savings accounts each
weekend has rendered the reserve requirement irrelevant.
9. *Explain how an absence of understanding in the US of the relationship between
the central bank’s balance sheet and the money supply contributed to the Great
Depression.
Answer: During the Great Depression, the central bank was increasing the monetary
base at a significant rate. Conditions in the economy, however, meant that the money
multiplier was declining and so the overall impact was a fall in quantity of money.
This contributed to the contraction of the economy.
14
