Money and Banking

1
Money and Banking

• Spring 2007
• Martin Andreas Wurm
• University of Wisconsin - Milwaukee

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Central Banking

• Required Reading Mishkin, Chapter 14

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Central Banking

• 1. Origins and Formal Structure of the Federal
  Reserve System
• The central bank of the U.S. is call the Federal
  Reserve System or plainly the Fed and was
  established in 1913 through the Federal Reserve
  Act
• Two attempts to establish a U.S. central bank
  preceding the Federal Reserve System in the 19th
  century had failed due to public mistrust in
  centralization and moneyed interests.
• The First Bank of the United States was disbanded
  in 1811 and the Second Bank of the United States
  was disbanded in 1836

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Central Banking

• 1. Origins and Formal Structure of the Federal
  Reserve System
• Left without a lender of last resort or any other
  safety mechanism the U.S. banking system in the
  19th and early 20th century became subject to
  frequent banking crises
• The year 1907 brought a severe national banking
  panic with widespread losses of deposits, and the
  necessity of a central bank was ultimately
  accepted by the public.
• Nevertheless, fear of centralization in form of a
  single bank like the Bank of England led to the
  complex system known as the Federal Reserve
  System.

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Central Banking

• 1. Origins and Formal Structure of the Federal
  Reserve System
• The original idea behind the Federal Reserve
  System was to spread out monetary authority
  between the private sector, the government,
  bankers, businesspeople and the public.
• The entities which have come out of this
  intention are
• The Federal Reserve Banks,
• The Board of Governors of the Federal Reserve
  System
• The Federal Open Market Committee (FOMC),
• The Federal Advisory council
• and commercial member banks

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Central Banking

• 1.1. Federal Reserve Banks
• There are 12 Federal Reserve Banks (Boston, New
  York, Philadelphia, Richmond, Cleveland, Atlanta,
  Chicago, St. Louis, Minneapolis, Kansas City,
  Dallas, San Francisco) in the U.S. which can have
  branches in other cities in their districts
• The Federal Reserve Banks are quasi-public
  institutions owned by private commercial member
  banks in each district.
• Member banks elect six directors to each district
  bank. Three more are appointed by the Board of
  Governors. The nine directors finally appoint the
  President of each bank

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Central Banking

• 1.1. Federal Reserve Banks
• Three of these nine directors are professional
  bankers, three are prominent leaders from
  industry, agriculture, etc. and the three
  directors appointed by the Board of Governors are
  supposed to represent public interests.
• The Federal Reserve Banks fulfill a variety of
  functions, where the Federal Reserve Bank in New
  York additionally handles open market operations
  and foreign exchange interventions by the system

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Central Banking

• 1.1. Federal Reserve Banks
• These functions are
• Clearing of checks
• Issuance of new currency
• Withdraw damaged currency from circulation
• Administration of discount loans to banks in
  their districts
• Evaluate proposed mergers and other expansive
  activities by banks
• Facilitate communication between the business
  community and the Federal Reserve System
• Examine bank holding companies and
  state-chartered member banks
• Collect data on local business conditions
• Large research activity in topics related to
  macro- / monetary economics

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Central Banking

• 1.1. Federal Reserve Banks
• Further, the Federal Reserve Banks are engaged in
  monetary policy
• 1. They establish the discount rate in their
  district (which, however, is reviewed and
  determined by the Board of Governors)
• 1. They decide which banks can obtain discount
  loans
• 3. The Federal Reserve Banks select a commercial
  banker from each district to the Federal Advisory
  Council, which consults the Board of Governors
  and provides information regarding monetary
  policy
• 4. 5 of the 12 directors have a vote on the FOMCs
  open market policy decisions (The New York
  District Bank has a permanent vote).

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Central Banking

• 1.2. Member Banks
• All national banks (by requirement) are member
  banks of the system. State-chartered banks can
  join the system. Currently roughly 40 of all
  commercial banks in the U.S. are members.
• Originally nonmember banks were not required to
  hold reserves at the Federal Reserve Banks, but
  due to concerns by the Board of Governors over
  declining membership legislation was pushed
  through in the 1980s which now requires nonmember
  banks to hold the same requirements as member
  banks.

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Central Banking

• 1.3. Board of Governors of the Federal Reserve
  System
• The Board of Governors is located in Washington
  D.C. and presides over the Federal Reserve
  System.
• The Board of Governors consists of 7 members each
  of which are appointed by the U.S. President and
  have to be confirmed by the Senate.
• In order to limit political influence on the
  system each governor serves a nonrenewable
  14-year term, one expiring every other January.
  All governors have to originate from different
  district.

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Central Banking

• 1.3. Board of Governors of the Federal Reserve
  System
• The chairman of the governor is chosen from the
  seven governors and serves a 4 year term. If he
  is not reappointed by the end of this period he
  usually resigns from the Board of Governors.
• All members of the Board of Governors are also
  members of the FOMC in which they form a
  majority. Its influence on monetary policy is,
  thus, predominant.
• Further, the Board sets reserve requirements,
  which are another tool of monetary policy and
  effectively the discount rate.

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Central Banking

• 1.3. Board of Governors of the Federal Reserve
  System
• Further, the Boards chairman is an important
  policy advisor to the President and Congress. He
  also is the major public voice of the Federal
  Reserve System and large attention is given to
  his words.
• Currently Ben Bernanke has taken over as chairman
  of the Board of Governors succeeding Alan
  Greenspan in February 2006. He is expected to
  follow a stronger commitment to price stability
  than his predecessor - announcing the
  introduction of inflation targeting into U.S.
  monetary policy.

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Central Banking

• 1.3. Board of Governors of the Federal Reserve
  System
• The Board of Governors often has been given other
  duties such as the enforcement of maximum
  interest rates payable on deposits (Regulation
  Q), regulation and control of credit practices,
  margin requirements, national bank mergers, etc.
• Further, the Board of Governors is involved in a
  variety of administrative activities, such as
  setting the salaries of the Federal Reserves
  employees, etc.

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Central Banking

• 1.4. The Federal Open Market Committee
• FOMC meetings follow a rigid standard procedure
  (for details see Mishkin p.343)
• During this meetings reports on domestic and
  foreign open market policy, as well as national
  and regional economic outlooks are read out and
  subsequently monetary issues are debated - again
  following a strict procedure.
• Finally the FOMC votes on potential changes in
  the discount and targeted federal funds rate,
  which are then announced to the public.

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Central Banking

• 2. Informal Structure of the Federal Reserve
  System
• While the above discussion already stressed the
  strong role of the Board of Governors through its
  impact on monetary policy it understates the role
  of the chairman of the Board of Governors.
• Traditionally the Feds chairmen have exerted
  great influence on the Board of Governors and the
  FOMC. They set e.g. the agenda for the Board of
  Governors regular activity as well as for the
  FOMCs decision making. Further they supervise the
  advisory board staff to the FOMC.
• Historically strong personalities such as Alan
  Greenspan or Paul Volcker have had strong
  influence on monetary policy through their
  position as chairman of the Board of Governors.

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Central Banking

• 3. Independence of the Federal Reserve
• One of the major issues when discussing central
  banking in general is the question, how
  independent a central bank should/can be from
  other political influences.
• In particular, there are two types of
  independence
• Instrument independence (how to conduct monetary
  policy) and goal independence (which aims to
  follow) for monetary policy.

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Central Banking

• 3. Independence of the Federal Reserve
• The Federal Reserve System is considered
  independent in both aspects - how to conduct
  monetary policy and which aims to pursue and
  traditionally is regarded as one of the most
  independent central banks worldwide next only
  to the Swiss national bank and the
  ECB/Bundesbank.
• A big chunk of this independence comes from the
  fact that the Federal Reserve produces several
  billions (around 20) of Dollars in net earnings
  per year and, thus, is free from policy
  subsidies/funding.
• Further regulations, such as the one-term
  appointment of governors are supposed to limit
  the impact a certain administration can exert on
  the Federal Reserve System.

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Central Banking

• 3. Independence of the Federal Reserve
• Nevertheless, the Fed is not fully independent
• Congress has threatened on several occasions to
  take over the Feds finances and treat it like
  any other government agency.
• Further, the Feds rights are entirely granted by
  legislation, so that Congress has occasionally
  forced the Fed to adopt certain reporting
  standards, etc.
• Further, the President exerts certain influence
  on the Fed through his role in Congress, his
  frequent appointment of Governors (since many
  Governors do not serve their full term) and
  through the appointment of the chairman every
  four years.

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Central Banking

• 4. A look abroad Important Central Banks and
  Independence
• 1. The Bank of England
• The Bank of England established in 1694 is the
  oldest central bank in the world.
• While being the holder of the reserve currency in
  the world until the end of World War II, the Bank
  of England was and is considered a relatively
  dependent central bank. The decision over
  interest rates resided with the chancellor of the
  Exchequer (i.e. the treasury) until 1997.
• Even though under New Labour the Bank of England
  was granted the right to set interest rates, the
  government still can overrule its decision in
  rare circumstances. Further, the Chancellor of
  the Exchequer issues inflation targets for the
  British Economy.

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Central Banking

• 4. A look abroad Important Central Banks and
  Independence
• 1. The Bank of Japan
• Established in 1882 the Japanese Ministry of
  Finance traditionally had strong influences on
  monetary policy with direct votes in the Monetary
  Policy Board and strong control over the Bank of
  Japans operations
• In 1998 partly due to Japans problems with
  deflation- the Bank of Japan was granted a large
  set of rights basically rendering it independent
  from policy. The only political influence left is
  the Ministry of Finances budget right over
  nonmonetary activities of the Bank of Japan.

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Central Banking

• 4. A look abroad Important Central Banks and
  Independence
• 3. The European Central Bank
• The European Central Bank was established as part
  of the Maastricht Treaty in 1999 and exhibits a
  similar structure as the Federal Reserve System,
  with the former national central banks fulfilling
  similar functions as the Federal Reserve Banks.
• The European Central Bank is considered the most
  independent Central Bank in the world, since
  neither the European Union nor the national
  governments have any control over monetary
  policy.
• Further its legal status is fixed by the
  Maastricht treaty rather than by legislation and
  can only be changed if all member countries
  approve.
• The European Central Bank follows the
  Bundesbanks tradition of pursuing strong price
  stability as major goal.

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Central Banking

• 5. Why does independence matter?
• Over the last decades we have witnessed a strong
  worldwide trend towards greater independence of
  central banks from the influence of politics.
• Economically independence of central banking is
  debated and arguments have brought forward both
  in favor and against it. At large the consesus
  favors independence, although there are some
  caveats in this discussion to be wary of.

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Central Banking

• 5. Why does independence matter?
• The Case for Independence
• The major argument for the independence of
  central banks is that politics in democratic
  societies are normally more driven by short-run
  objectives than long-run intentions (a variation
  of this is the political business cycle). This
  might lead to inflationary monetary policy, since
  short run reductions in interest rates are mostly
  bought at higher medium run inflation.
• Related to this concern is the fact that central
  bank behavior puts certain constraints on fiscal
  policy. Strategies such as having the central
  bank buy fiscal debt like T-bonds and inflating
  away fiscal debt are hoped to be ruled out if a
  central bank is independent.

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Central Banking

• 5. Why does independence matter?
• The Case for Independence
• Finally it has been argued that politicians
  simply do not have the necessary expertise and
  incentives to take care of something as important
  as monetary policy.
• Politics at large have shown little success in
  tackling economic issues of similar significance
  such as banking reform or deficit reduction.

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Central Banking

• 5. Why does independence matter?
• The Case against Independence
• It has been argued that elites such as the
  Federal Reserve System represent an undemocratic
  element in a democracy, especially since there is
  no reason to assume that its members do not act
  on behalf of their own self-interest.
• Further, the amount of accountability of the
  Federal Reserve is limited. If the Feds
  performance is bad, there is no provision for
  replacing its members.
• Further, there is some historical evidence, that
  independence does not grant stable monetary
  policy. In particular the Fed is viewed as having
  failed to provide the financial system with
  enough liquidity as lender of last resort during
  the Great Depression leading to one of the most
  persistent crisis in U.S. history.

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Central Banking

• 5. Why does independence matter?
• Conclusion
• The question whether independence is positive, is
  ultimately an open one. It has only been shown
  that countries with the largest level of
  independence have the best inflationary
  performance.
• However, inflation at controllable levels-
  cannot necessarily be shown to have a negative
  impact on general economic performance of a
  country. Thus, it might not be the ideal,
  exclusive goal for monetary policy.