Ch13 Mishkin 09

Chapter 13
Central Banks
and the Federal
Reserve System
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

The Price Stability Goal
• 1- Low and stable inflation

• 2- Inflation
– A. Creates uncertainty and difficulty in planning
for the future
– B. Lowers economic growth
– C. Strains social fabric
• 3- Nominal anchor to contain inflation
expectations
• 4- Time-inconsistency problem
13-2
Other Goals of Monetary
Policy
• 1- High employment
• 2- Economic growth
• 3- Stability of financial markets
• 4- Interest-rate stability
• 5- Foreign exchange market stability
13-3
Should Price Stability be the
Primary Goal?
• 1- In the long run there is no conflict
between the goals
• 2- In the short run it can conflict with the
goals of high employment and interest-rate
stability
13-4
Origins of the Federal
Reserve System
• 1- Resistance to establishment of a central
bank
– A. Fear of centralized power
– B. Distrust of moneyed interests
• 2- No lender of last resort
– A. Nationwide bank panics on a regular basis
– B. Panic of 1907 so severe that the public was
convinced a central bank was needed
• 3- Federal Reserve Act of 1913
– Elaborate system of checks and balances
– Decentralized
13-5
Federal Reserve Banks
• Quasi-public institution owned by private

commercial banks in the district that are members
of the Fed system
• Member banks elect six directors for each district;
three more are appointed by the Board of
Governors
– Three A directors are professional bankers
– Three B directors are prominent leaders from industry,
labor, agriculture, or consumer sector
– Three C directors appointed by the Board of Governors
are not allowed to be officers, employees, or stockholders
of banks
13-6
Federal Reserve Banks
(cont’d)
• Member banks elect six directors for each district; three more
are appointed by the Board of Governors
– Designed to reflect all constituencies of the public
• Nine directors appoint the president of the bank subject to
approval by Board of Governors
13-7
Functions of the Federal
Reserve Banks
• 1- Clear checks
• 2- Issue new currency
• 3- Withdraw damaged currency from
circulation
• 4- Administer and make discount loans to
banks in their districts
• 5- Evaluate proposed mergers and
applications for banks to expand their
activities
13-8
Functions of the Federal
Reserve Banks (cont’d)
• 6- Act as contact between the business community
and the Federal Reserve System
• 7- Examine bank holding companies and state-
chartered member banks
• 8- Collect data on local business conditions
• 9- Use staffs of professional economists to research
topics related to the conduct of monetary policy
13-9
Federal Reserve Banks and
Monetary Policy
• 1- Directors “establish” the discount rate
• 2- Decide which banks can obtain discount loans
• 3- Directors select one commercial banker from
each district to serve on the Federal Advisory
Council which consults with the Board of Governors
and provides information to help conduct monetary
policy
• Five of the 12 bank presidents have a vote in the
Federal Open Market Committee (FOMC)
13-10
Member Banks
• 1- All national banks are required to be

members of the Federal Reserve System
• 2- Commercial banks chartered by states
are not required but may choose to be
members
• 3- Depository Institutions Deregulation and
Monetary Control Act of 1980 subjected all
banks to the same reserve requirements as
member banks and gave all banks access to
Federal Reserve facilities
13-11
Board of Governors of the
Federal Reserve System
• 1- Seven members headquartered in
Washington, D.C.
• 2- Appointed by the president and confirmed
by the Senate
• 3- 14-year non-renewable term
• 4- Required to come from different districts
• 4- Chairman is chosen from the governors
and serves four-year term
13-12
Duties of the Board of
Governors
• 1- Votes on conduct of open market
operations
• 2- Sets reserve requirements
• 3- Controls the discount rate through
“review and determination” process
• 4- Sets margin requirements
• 5- Sets salaries of president and officers of
each Federal Reserve Bank and reviews each
bank’s budget
13-13
Duties of the Board of
Governors (cont’d)
• 6- Approves bank mergers and applications
for new activities
• 7- Specifies the permissible activities of
bank holding companies
• 8- Supervises the activities of foreign banks
operating in the U.S.
13-14
Chairman of the Board of
Governors
• 1- Advises the president on economic policy
• 2- Testifies in Congress
• 3- Speaks for the Federal Reserve System to
the media
• 4- May represent the U.S. in negotiations
with foreign governments on economic
matters
13-15
Federal Open Market
Committee (FOMC)
• 1- Meets eight times a year
• 2- Consists of seven members of the Board of
Governors, the president of the Federal Reserve
Bank of New York and the presidents of four other
Federal Reserve banks
• 3- Chairman of the Board of Governors is also chair
of FOMC
• 4- Issues directives to the trading desk at the
Federal Reserve Bank of New York
13-16
How Independent is the Fed?
• 1- Instrument and goal independence.

• 2- Independent revenue
• 3- Fed’s structure is written by Congress,
and is subject to change at any time.
• Presidential influence
1- Influence on Congress
2- Appoints members
3- Appoints chairman although terms are not
concurrent
13-17
Structure and Independence of
Other Foreign Central Banks
• 1- Bank of Canada
– Essentially controls monetary policy
• 2- Bank of England
– Has some instrument independence.
• 3- Bank of Japan
– Recently (1998) gained more independence
• The trend toward greater independence
13-18
Central Bank Behavior
• Theory of bureaucratic behavior:

objective is to maximize its own welfare
which is related to power and prestige
1-Fight vigorously to preserve autonomy
2- Avoid conflict with more powerful groups
• Does not rule out altruism
13-19
Case for Independence
• 1- Political pressure would impart an

inflationary bias to monetary policy
• 2- Political business cycle
• 3- Could be used to facilitate Treasury
financing of large budget deficits:
accommodation
• 4- Too important to leave to politicians—the
principal-agent problem is worse for
politicians
13-20
Case Against Independence
• 1- Undemocratic
• 2- Unaccountable
• 3- Difficult to coordinate fiscal and monetary
policy
• 4- Has not used its independence
successfully
13-21

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Chapter 13

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

• 1- Low and stable inflation

• Quasi-public institution owned by private

• 1- All national banks are required to be

• 1- Instrument and goal independence.

• Theory of bureaucratic behavior:

• Does not rule out altruism

• 1- Political pressure would impart an

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