The economics of money, banking, and financial markets (10th edition) part 2

The locations of these districts, the Federal FIgure 1 Structure and responsibility for policy tools in the Federal reserve System The relationships of the Federal Reserve banks, the Boa

Central Banking and the Conduct of Monetary Policy

Crisis and Response: The Federal Reserve and the Global Financial Crisis

When the Federal Reserve was confronted with what former man Alan Greenspan described as a “once-in-a-century credit tsu-nami,” it resolved to come to the rescue Starting in September 2007, the Federal Reserve lowered the federal funds rate target, bringing it down to zero by the end of 2008 At the same time, the Fed imple-mented large liquidity injections into the credit markets to try to get them lending again In mid-August 2007, the Fed lowered the discount rate at which it lent to banks to just 50 basis points above the federal funds rate target from the normal 100 basis points Over the course of the crisis, the Fed broadened its provision of liquidity to the financial system well outside its traditional lending to depository institutions Indeed, after the Fed made loans to assist in the takeover

Chair-of Bear Stearns by J.P Morgan in March 2008, Paul Volcker, a former Chairman of the Federal Reserve, described the Fed’s actions as going

to the “very edge of its lawful and implied powers.” The number of new Fed lending programs over the course of the crisis spawned a whole new set of acronyms—the TAF, TSLF, PDCF, AMLF, CPFF, and MMIFF—making the Fed sound like the Pentagon with code-named initiatives and weapons Like the Pentagon, the Fed was fighting a war, although its weapons were financial rather than guns, tanks, or aircraft

The recent global financial crisis has demonstrated the tance of central banks like the Federal Reserve to the health of the financial system and the economy Chapter 13 outlines what central banks are trying to achieve, what motivates them, and how they are set up Chapter 14 describes how the money supply is determined

impor-In Chapter 15, we look at the tools that central banks like the Fed have at their disposal and how they use them Chapter 16 extends the discussion of how monetary policy is conducted to focus on the broader picture of central banks’ strategies and tactics

4

Part

Among the most important players in financial markets throughout the world are

central banks, the government authorities in charge of monetary policy Central banks’ actions affect interest rates, the amount of credit, and the money supply, all of which have direct impacts not only on financial markets, but also on aggregate output and inflation To understand the role that central banks play in financial markets and the overall economy, we need to understand how these organizations work Who controls central banks and determines their actions? What motivates their behavior? Who holds the reins of power?

In this chapter, we look at the institutional structure of major central banks, and focus particularly on the Federal Reserve System, one of the most important central banks in the world We start by examining the elements of the Fed’s institutional struc-ture that determine where the true power within the Federal Reserve System lies By understanding who makes the decisions, we will have a better idea of how they are made We then examine what explains central bank behavior and whether it is a good idea to make central banks independent by insulating them from politicians Finally, we look at the structure and independence of other major central banks, particularly the European Central Bank With this context in place, we will be prepared to comprehend the actual conduct of monetary policy described in the following chapters

Origins Of The federAl reserve sysTem

Of all the central banks in the world, the Federal Reserve System probably has the most unusual structure To understand why this structure arose, we must go back to before

1913, when the Federal Reserve System was created

Before the twentieth century, a major characteristic of American politics was the fear of centralized power, as seen in the checks and balances of the Constitution and the preservation of states’ rights This fear of centralized power was one source of American resistance to the establishment of a central bank Another source was the traditional American distrust of moneyed interests, the most prominent symbol of which was a central bank The open hostility of the American public to the existence of a central bank resulted in the demise of the first two experiments in central banking, whose function was to police the banking system: The First Bank of the United States was disbanded in 1811, and the national charter of the Second Bank of the United States expired in 1836 after its renewal was vetoed in 1832 by President Andrew Jackson

Central Banks and the federal reserve system

Preview

13

302

The termination of the Second Bank’s national charter in 1836 created a severe lem for American financial markets, because there was no lender of last resort that could provide reserves to the banking system to avert a bank panic Hence, in the nineteenth and early twentieth centuries, nationwide bank panics became a regular event, occurring every twenty years or so, culminating in the panic of 1907 The 1907 panic resulted in such widespread bank failures and such substantial losses to depositors that the public was finally convinced that a central bank was needed to prevent future panics.

prob-The hostility of the American public to banks and centralized authority created great opposition to the establishment of a single central bank like the Bank of England Fear was rampant that the moneyed interests on Wall Street (including the largest cor-porations and banks) would be able to manipulate such an institution to gain control over the economy and that federal operation of the central bank might result in too much government intervention in the affairs of private banks Serious disagreements existed over whether the central bank should be a private bank or a government insti-tution Because of the heated debates on these issues, a compromise was struck In the great American tradition, Congress wrote an elaborate system of checks and balances into the Federal Reserve Act of 1913, which created the Federal Reserve System with its twelve regional Federal Reserve banks (see the Inside the Fed box, “The Political Genius

of the Founders of the Federal Reserve System”)

sTruCTure Of The federAl reserve sysTem

The writers of the Federal Reserve Act wanted to diffuse power along regional lines, between the private sector and the government, and among bankers, business people, and the public This initial diffusion of power has resulted in the evolution of the Fed-

eral Reserve System to include the following entities: the Federal Reserve banks, the

Inside the Fed The Political Genius of the Founders of the Federal

Reserve System

The history of the United States has been one of

pub-lic hostility to banks and especially to a central bank

How were the politicians who founded the Federal

Reserve able to design a system that has become one

of the most prestigious institutions in the United

States?

The answer is that the founders recognized that

if power was too concentrated in either Washington,

DC, or New York, cities that Americans often love

to hate, an American central bank might not have

enough public support to operate effectively They

thus decided to set up a decentralized system with

twelve Federal Reserve banks spread throughout the

country to make sure that all regions of the country were represented in monetary policy deliberations

In addition, they made the Federal Reserve banks quasi-private institutions overseen by directors from the private sector living in each district who repre-sent views from their region and are in close contact with the president of their Federal Reserve bank The unusual structure of the Federal Reserve System has promoted a concern in the Fed with regional issues,

as is evident in Federal Reserve bank publications Without this unusual structure, the Federal Reserve System might have been far less popular with the public, making the institution far less effective

Board of Governors of the Federal Reserve System, the Federal Open Market Committee (FOMC), the Federal Advisory Council, and around 2,500 member com-

mercial banks Figure 1 outlines the relationships of these entities to one another and to the three policy tools of the Fed (open market operations, the discount rate, and reserve requirements) discussed in Chapters 14 and 15

Federal reserve Banks

Each of the twelve Federal Reserve districts has one main Federal Reserve bank, which may have branches in other cities in the district The locations of these districts, the Federal

FIgure 1 Structure and responsibility for policy tools in the Federal reserve System

The relationships of the Federal Reserve banks, the Board of Governors of the Federal Reserve System,

and the FOMC to the three policy tools of the Fed (open market operations, the discount rate, and reserve requirements) Dashed lines indicate that the FOMC “advises” on the setting of reserve requirements and the discount rate.

Twelve Federal Reserve Banks (FRBs)

Each with nine directors who appoint president and other officers of the FRB

Open market operations

Board of Governors

Seven members, including

the chairman, appointed

by the president of

the United States and

confirmed by the Senate

Reviews and determines

Appoints three directors to each FRB

Elect six directors to each FRB

Federal Advisory Council

Twelve members (bankers), one from each district

Discount rate

Reserve requirements

Select

Sets (within limits)

Around 2,500 member commercial banks

Member Banks

Reserve banks, and their branches are shown in Figure 2 The three largest Federal Reserve banks in terms of assets are those of New York, Chicago, and San Francisco—combined they hold more than 50% of the assets (discount loans, securities, and other holdings) of the Federal Reserve System The New York bank, with around one-quarter of the assets,

is the most important of the Federal Reserve banks (see Inside the Fed box, “The Special Role of the Federal Reserve Bank of New York”)

Each of the Federal Reserve banks is a quasi-public (part private, part government) institution owned by the private commercial banks in its district that are members of the Federal Reserve System These member banks have purchased stock in their dis-trict Federal Reserve bank (a requirement of membership), and the dividends paid by that stock are limited by law to 6% annually The member banks elect six directors for each district bank; three more are appointed by the Board of Governors The directors

of a district bank are classified into three categories: A, B, and C The three A directors (elected by the member banks) are professional bankers, and the three B directors (also elected by the member banks) are prominent leaders from industry, labor, agriculture,

or the consumer sector The three C directors, who are appointed by the Board of Governors to represent the public interest, are not allowed to be officers, employees, or stockholders of banks The directors oversee the activities of the district bank, but their

Miami

12

4 10

9

11

6

5 3

1 2 7

Jacksonville Atlanta

New York

Boston Buffalo

Detroit

Salt Lake City

Houston

New Orleans

Nashville Louisville

Richmond WASHINGTON Baltimore Philadelphia

Denver San Francisco

San Antonio

Charlotte

Pittsburgh

Cleveland Cincinnati

Birmingham

Board of Governors of the Federal

Reserve System

Federal Reserve bank cities

Boundaries of Federal Reserve districts

(Alaska and Hawaii are in District 12)

Federal Reserve branch cities

Federal Reserve districts

1

FIgure 2 Federal reserve System

The locations of the Federal Reserve districts, the Federal Reserve banks, and their branches.

Source: federal reserve Bulletin.

most important job is to appoint the president of the bank (subject to the approval of the Board of Governors) Up until 2010, all nine directors participated in this decision, but the Dodd-Frank legislation in July 2010 excluded the three class A directors from involvement in choosing the president of the bank Congress viewed it as inappropriate for bankers to be involved in choosing the president of the Federal Reserve bank that would have supervisory oversight of these same banks.

The twelve Federal Reserve banks are involved in monetary policy in several ways:

• Their directors “establish” the discount rate (although the discount rate in each district is reviewed and determined by the Board of Governors)

• They decide which banks, member and nonmember alike, can obtain discount loans from the Federal Reserve bank

• Their directors select one commercial banker from each bank’s district to serve on the Federal Advisory Council, which consults with the Board of Governors and provides information that helps in the conduct of monetary policy

• Five of the twelve bank presidents each have a vote on the Federal Open Market

Committee, which directs open market operations (the purchase and sale of

gov-ernment securities that affect both interest rates and the amount of reserves in the banking system) As explained in the Inside the Fed box, “The Special Role of the Federal Reserve Bank of New York,” because the president of the New York Fed is a permanent member of the FOMC, he or she always has a vote on the FOMC, mak-ing it the most important of the banks; the other four votes allocated to the district banks rotate annually among the remaining eleven presidents

The twelve Federal Reserve banks also perform the following functions:

All national banks (commercial banks chartered by the Office of the Comptroller of

the Currency) are required to be members of the Federal Reserve System Commercial banks chartered by the states are not required to be members, but they can choose to join Currently, about a third of the commercial banks in the United States are members

of the Federal Reserve System, having declined from a peak figure of 49% in 1947.Before 1980, only member banks were required to keep reserves as deposits at the Federal Reserve banks Nonmember banks were subject to reserve requirements deter-mined by their states, which typically allowed them to hold much of their reserves in interest-bearing securities Because at the time no interest was paid on reserves deposited

at the Federal Reserve banks, it was costly to be a member of the system, and as interest rates rose, the relative cost of membership rose, and more and more banks left the system.This decline in Fed membership was a major concern of the Board of Governors; one reason was that it lessened the Fed’s control over the money supply, making it

more difficult for the Fed to conduct monetary policy The chairman of the Board of Governors repeatedly called for new legislation requiring all commercial banks to be members of the Federal Reserve System One result of the Fed’s pressure on Congress was a provision in the Depository Institutions Deregulation and Monetary Control Act

of 1980: All depository institutions became subject (by 1987) to the same ments to keep deposits at the Fed, so member and nonmember banks would be on

require-an equal footing in terms of reserve requirements In addition, all depository tions were given access to the Federal Reserve facilities, such as the discount window (discussed in Chapter 15) and Fed check clearing, on an equal basis These provisions ended the decline in Fed membership and reduced the distinction between member and nonmember banks

institu-Inside the Fed The Special Role of the Federal Reserve Bank of New York

The Federal Reserve Bank of New York plays a special

role in the Federal Reserve System for several reasons

First, its district contains many of the largest

com-mercial banks in the United States, the safety and

soundness of which are paramount to the health of

the U.S financial system The Federal Reserve Bank

of New York conducts examinations of bank

hold-ing companies and state-chartered member banks in

its district, making it the supervisor of some of the

most important financial institutions in our financial

system Not surprisingly, given this responsibility, the

bank supervision group is one of the largest units

of the New York Fed and is by far the largest bank

supervision group in the Federal Reserve System

The second reason for the New York Fed’s special

role is its active involvement in the bond and foreign

exchange markets The New York Fed houses the

open market desk, which conducts open market

operations—the purchase and sale of bonds—that

determine the amount of reserves in the banking

system Because of this involvement in the Treasury

securities market, as well as its walking-distance

location near the New York Stock Exchange, the

officials at the Federal Reserve Bank of New York are

in constant contact with the major domestic financial

markets in the United States In addition, the

Fed-eral Reserve Bank of New York houses the foreign

exchange desk, which conducts foreign exchange

interventions on behalf of the Federal Reserve

Sys-tem and the U.S Treasury Its involvement in these

financial markets means that the New York Fed is

an important source of information on what is pening in domestic and foreign financial markets, particularly during crisis periods such as the recent subprime meltdown, as well as a liaison between officials in the Federal Reserve System and private participants in the markets

hap-The third reason for the Federal Reserve Bank of New York’s prominence is that it is the only Federal Reserve bank to be a member of the Bank for Inter-national Settlements (BIS) Thus the president of the New York Fed, along with the chairman of the Board

of Governors, represents the Federal Reserve System

in its regular monthly meetings with other major central bankers at the BIS This close contact with foreign central bankers and interaction with foreign exchange markets means that the New York Fed has a special role in international relations, both with other central bankers and with private market participants Adding to its prominence in international circles, the New York Fed is the repository for more than $100 billion of the world’s gold, an amount greater than the gold at Fort Knox

Finally, the president of the Federal Reserve Bank

of New York is the only permanent voting member

of the FOMC among the Federal Reserve bank dents, serving as the vice-chairman of the committee Thus he and the chairman and vice-chairman of the Board of Governors are the three most important officials in the Federal Reserve System

presi-Board of governors of the Federal reserve System

At the head of the Federal Reserve System is the seven-member Board of Governors, headquartered in Washington, DC Each governor is appointed by the president of the United States and confirmed by the Senate To limit the president’s control over the Fed and insulate the Fed from other political pressures, the governors can serve one full nonrenewable fourteen-year term plus part of another term, with one governor’s term expiring every other January.1 The governors (many are professional economists) are required to come from different Federal Reserve districts to prevent the interests of one region of the country from being overrepresented The chairman of the Board of Governors is chosen from among the seven governors and serves a four-year, renewable term It is expected that once a new chairman is chosen, the old chairman resigns from the Board of Governors, even if many years are left in his or her term as a governor.The Board of Governors is actively involved in the conduct of monetary policy in the following ways:

• All seven governors are members of the FOMC and vote on the conduct of open market operations Because only twelve voting members are on this committee (seven governors and five presidents of the district banks), the Board has the majority of the votes

• It sets reserve requirements (within limits imposed by legislation)

• It effectively controls the discount rate by the “review and determination” process, whereby it approves or disapproves the discount rate “established” by the Federal Reserve banks

• The chairman of the Board advises the president of the United States on economic policy, testifies in Congress, and speaks for the Federal Reserve System to the media.Through legislation, the Board of Governors has often been given duties not directly related to the conduct of monetary policy, which are as follows:

• Sets margin requirements, the fraction of the purchase price of securities that has to

be paid for with cash rather than borrowed funds

• Sets the salary of the president and all officers of each Federal Reserve bank and reviews each bank’s budget

• sible activities of bank holding companies, and supervises the activities of foreign banks in the United States

Approves bank mergers and applications for new activities, specifies the permis-• serve banks), which provides economic analysis that the Board of Governors uses in making its decisions (see the Inside the Fed box, “The Role of the Research Staff”)

Has a staff of professional economists (larger than those of individual Federal Re-Federal Open Market Committee (FOMC)

The FOMC usually meets eight times a year (about every six weeks) and makes sions regarding the conduct of open market operations and the setting of the policy

deci-interest rate, the federal funds rate, which is the deci-interest rate on overnight loans from

1 Although technically the governor’s term is nonrenewable, a governor can resign just before the term expires and then be reappointed by the president This explains how one governor, William McChesney Martin, Jr., served for

28 years Since Martin, the chairman from 1951 to 1970, retired from the board in 1970, the practice of allowing

a governor to in effect serve a second full term has not been done, and this is why Alan Greenspan had to retire from the Board after his fourteen-year term expired in 2006.

Inside the Fed The Role of the Research Staff

The Federal Reserve System is the largest employer of

economists not just in the United States, but in the

world The system’s research staff has approximately

1,000 people, about half of whom are economists

Of these 500 economists, about 250 are at the Board

of Governors, 100 are at the Federal Reserve Bank of

New York, and the remainder are at the other Federal

Reserve banks What do all these economists do?

The most important task of the Fed’s economists is

to follow the incoming data from government

agen-cies and private sector organizations on the economy

and provide guidance to the policy makers on where

the economy may be heading and what the impact

of monetary policy actions on the economy might

be Before each FOMC meeting, the research staff at

each Federal Reserve bank briefs its president and

the senior management of the bank on its forecast

for the U.S economy and the issues that are likely to

be discussed at the meeting The research staff also

provides briefing materials or a formal briefing on the

economic outlook for the bank’s region, something

that each president discusses at the FOMC meeting

Meanwhile, at the Board of Governors, economists

maintain a large econometric model (a model whose

equations are estimated with statistical procedures)

that helps them produce their forecasts of the

national economy, and they, too, brief the governors

on the national economic outlook

The research staffers at the banks and the board

also provide support for the bank supervisory staff,

tracking developments in the banking sector and

other financial markets and institutions and

supply-ing bank examiners with technical advice they might

need in the course of their examinations Because

the Board of Governors has to decide whether to

approve bank mergers, the research staffs at both

the Board and the bank in whose district the merger

is to take place prepare information on what effect the proposed merger might have on the competitive environment To ensure compliance with the Com-munity Reinvestment Act, economists also analyze a bank’s performance in its lending activities in differ-ent communities

Because of the increased influence of ments in foreign countries on the U.S economy, members of the research staff, particularly those at the New York Fed and the Board, produce reports

develop-on the major foreign ecdevelop-onomies They also cdevelop-onduct research on developments in the foreign exchange market because of its growing importance in the monetary policy process and to support the activities

of the foreign exchange desk Economists help port the operation of the open market desk by pro-jecting reserve growth and the growth of monetary aggregates

sup-Staff economists also engage in basic research on the effects of monetary policy on output and infla-tion, developments in the labor markets, interna-tional trade, international capital markets, banking and other financial institutions, financial markets, and the regional economy, among other topics This research is published widely in academic journals and in Reserve Bank publications (Federal Reserve bank reviews are a good source of supplemental material for money and banking students.)

Another important activity of the research staff primarily at the Reserve Banks is in the public educa-tion area Staff economists are called on frequently to make presentations to the board of directors at their banks or to make speeches to the public in their district

one bank to another (How the FOMC meeting is conducted is discussed in the Inside the Fed box, “The FOMC Meeting,” and the documents produced for the meeting are described in the second Inside the Fed box, “Green, Blue, Teal, and Beige: What Do These Colors Mean at the Fed?”) Indeed, the FOMC is often referred to as the “Fed”

in the press For example, when the media say that the Fed is meeting, they actually mean that the FOMC is meeting The committee consists of the 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 The chairman of the Board of Governors also presides as the chairman of the FOMC Even though only the presidents of five of the Federal Reserve banks are voting members of the FOMC, the other seven presidents

of the district banks attend FOMC meetings and participate in discussions Hence they have some input into the committee’s decisions

Because open market operations are the most important policy tool the Fed has

for controlling the money supply and because it is where decisions about ing of monetary policy (a rise in the federal funds rate) or easing of monetary policy (a lowering of the federal funds rate) are made the FOMC is necessarily

tighten-the focal point for policy making in tighten-the Federal Reserve System Although reserve requirements and the discount rate are not actually set by the FOMC, decisions in regard to these policy tools are effectively made there, and this is why Figure 1 has dashed lines indicating that the FOMC “advises” on the setting of reserve require-ments and the discount rate The FOMC does not actually carry out securities purchases or sales Instead, it issues directives to the trading desk at the Federal Reserve Bank of New York, where the manager for domestic open market opera-tions supervises a roomful of people who execute the purchases and sales of the government or agency securities The manager communicates daily with the FOMC members and their staffs concerning the activities of the trading desk

The FOMC meeting takes place in the boardroom on

the second floor of the main building of the Board of

Governors in Washington, DC The seven governors

and the twelve Reserve Bank presidents, along with

the secretary of the FOMC, the Board’s director of

the Research and Statistics Division and his or her

deputy, and the directors of the Monetary Affairs and

International Finance Divisions, sit around a massive

conference table Although only five of the Reserve

Bank presidents have voting rights on the FOMC at

any given time, all actively participate in the

delib-erations Seated around the sides of the room are the

directors of research at each of the Reserve Banks and

other senior board and Reserve Bank officials, who,

by tradition, do not speak at the meeting

The meeting starts with a quick approval of the

minutes of the previous meeting of the FOMC The

first substantive agenda item is the report by the

man-ager of system open market operations on foreign

cur-rency and domestic open market operations and other

issues related to these topics After the governors and

Reserve Bank presidents finish asking questions and

discussing these reports, a vote is taken to ratify them

The next stage in the meeting is a presentation

of the Board staff’s national economic forecast by the director of the Research and Statistics Division

at the Board After the governors and Reserve Bank presidents have queried the division director about the forecast, the go-round occurs: Each bank presi-

dent presents an overview of economic conditions in his or her district and the bank’s assessment of the national outlook, and each governor, including the chairman, gives a view of the national outlook By tradition, remarks avoid the topic of monetary policy

discus-a question-discus-and-discus-answer period, ediscus-ach of the FOMC members, as well as the nonvoting bank presidents, expresses his or her views on monetary policy, and

on the monetary policy statement The chairman then summarizes the discussion and proposes specific

wording for the monetary policy statement and the

directive on the federal funds rate target transmitted

to the open market desk, indicating whether the

fed-eral funds rate target is to be raised or lowered, say, by

1/4 of a percentage point, or be left unchanged The

secretary of the FOMC formally reads the proposed

statement, and the members of the FOMC vote.*

Then there is an informal buffet lunch, and while

eating, the participants hear a presentation on the

lat-est developments in Congress on banking legislation

and other legislation relevant to the Federal Reserve

At 2:15 p.m a public announcement is made in

regard to the outcome of the meeting: whether the

federal funds rate target and discount rate have been

raised, lowered, or left unchanged, and an

assess-ment of the “balance of risks” in the future, whether

toward higher inflation or toward a weaker economy.†

The postmeeting announcement is an innovation initiated in 1994 Before then, no such announce-ment was made, and the markets had to guess what policy action was taken The decision to announce this information was a step in the direction of greater openness by the Fed A further step in this direction started in April 2011: After the FOMC meetings in April, June, November, and January, the Chairman of the Federal Reserve gives a press conference in which

he briefs the press about the FOMC decision

*The decisions expressed in the directive may not be unanimous, and the senting views are made public However, except in extremely rare cases, the chairman’s vote is always on the winning side.

dis-†Half of the meetings have a somewhat different format Rather than starting Tuesday morning at 9:00 a.m like the other meetings, they start in the after- noon on Tuesday and go over into Wednesday, with the usual announcement around 2:15 p.m These longer meetings also consider the longer-term eco- nomic outlook and special topics.

Inside the Fed Green, Blue, Teal, and Beige: What Do These Colors

Mean at the Fed?

Three research documents play an important

role in the monetary policy process and at Federal

Open Market Committee meetings Up until 2010,

a detailed national forecast for the next three years,

generated by the Federal Reserve Board of

Gover-nors’ Research and Statistics Division, was placed

between green covers and was thus known as the

“green book.” Projections for the monetary

aggre-gates prepared by the Monetary Affairs Division of

the Board of Governors, along with typically three

alternative scenarios for the stance of monetary

pol-icy (labeled A, B, and C), were contained in the “blue

book” in blue covers Both books were distributed to

all participants in FOMC meetings Starting in 2010, the green and blue books were combined into the

“teal book” with teal covers: Teal is a combination

of green and blue.* The “beige book,” with beige covers, is produced by the Reserve Banks and details evidence gleaned either from surveys or from talks with key businesses and financial institutions on the state of the economy in each of the Federal Reserve districts This is the only one of the three books that

is distributed publicly, and it often receives a lot of attention in the press

mem-the Board through mem-the force of stature and personality Chairmen of mem-the Board of nors (including Marriner S Eccles, William McChesney Martin, Jr., Arthur Burns, Paul

Gover-A Volcker, Alan Greenspan, and Ben Bernanke) have typically had strong personalities and have wielded great power

The chairman also exercises power by supervising the Board’s staff of professional economists and advisers Because the staff gathers information for the Board and con-ducts the analyses the Board uses in its decisions, it has some influence over monetary policy In addition, in the past, several appointments to the Board itself have come from within the ranks of its professional staff, making the chairman’s influence even farther-reaching and longer-lasting than a four-year term The chairman’s style also matters,

as the Inside the Fed box, “How Bernanke’s Style Differs from Greenspan’s,” suggests

hOw indePendenT is The fed?

When we look, in the next three chapters, at how the Federal Reserve conducts etary policy, we will want to know why it decides to take certain policy actions but not others To understand its actions, we must understand the incentives that motivate the Fed’s behavior How free is the Fed from presidential and congressional pressures? Do economic, bureaucratic, or political considerations guide it? Is the Fed truly independ-ent of outside pressures?

mon-Stanley Fischer, who was a professor at MIT and is now governor of the Bank of

Israel, has defined two different types of independence of central banks: instrument independence, the ability of the central bank to set monetary policy instruments, and goal independence, the ability of the central bank to set the goals of monetary policy

The Federal Reserve has both types of independence and is remarkably free of the political pressures that influence other government agencies Not only are the members

of the Board of Governors appointed for a fourteen-year term (and so cannot be ousted from office), but also the term is technically not renewable, eliminating some of the incentive for the governors to curry favor with the president and Congress

Probably even more important to its independence from the whims of Congress is the Fed’s independent and substantial source of revenue from its holdings of securities and, to

a lesser extent, from its loans to banks In 2010, for example, the Fed had net earnings after expenses of $80 billion—not a bad living if you can find it! Because it returns the bulk of these earnings to the Treasury, it does not get rich from its activities, but this income gives the Fed an important advantage over other government agencies: It is not subject to the appropriations process usually controlled by Congress Indeed, the General Accounting Office, the auditing agency of the federal government, cannot audit the monetary policy

or foreign exchange market functions of the Federal Reserve Because the power to control the purse strings is usually synonymous with the power of overall control, this feature of the Federal Reserve System contributes to its independence more than any other factor.Yet the Federal Reserve is still subject to the influence of Congress, because the legislation that structures it is written by Congress and is subject to change at any time When legislators are upset with the Fed’s conduct of monetary policy, they frequently threaten to weaken its independence A recent example was a bill sponsored by Repre-sentative Ron Paul in 2009 to subject the Fed’s monetary policy actions to audits by the General Accounting Office (GAO) Threats like this are a powerful club to wield, and they certainly have some effect in keeping the Fed from straying too far from congres-sional wishes

Congress has also passed legislation to make the Federal Reserve more accountable for its actions Under the Humphrey-Hawkins Act of 1978 and later legislation, the Federal Reserve is required to issue a Monetary Policy Report to the Congress semian-

nually, with accompanying testimony by the chairman of the Board of Governors, to explain how the conduct of monetary policy is consistent with the objectives given by the Federal Reserve Act

The president can also influence the Federal Reserve Because congressional tion can affect the Fed directly or affect its ability to conduct monetary policy, the president can be a powerful ally through his influence on Congress Second, although ostensibly a president might be able to appoint only one or two members to the Board of Governors during each presidential term, in actual practice the president appoints members far more often One reason is that most governors do not serve out a full fourteen-year term (Governors’ salaries are substantially below what they can earn in the private sector or even at universities, thus providing an incentive for them to return to academia or take private sector jobs before their term expires.) In addition, the president is able to appoint

legisla-a new chlegisla-airmlegisla-an of the Bolegisla-ard of Governors every four yelegisla-ars, legisla-and legisla-a chlegisla-airmlegisla-an who is not reappointed is expected to resign from the board so that a new member can be appointed.The power that the president enjoys through his appointments to the Board of Governors is limited, however Because the term of the chairman is not necessarily concurrent with that of the president, a president may have to deal with a chairman

of the Board of Governors appointed by a previous administration Alan Greenspan, for example, was appointed chairman in 1987 by President Ronald Reagan and was reappointed to another term by a Republican president, George H W Bush, in 1992 When Bill Clinton, a Democrat, became president in 1993, Greenspan had several years left to his term Clinton was put under tremendous pressure to reappoint Greenspan when his term expired and did so in 1996 and again in 2000, even though Greenspan

is a Republican.2 George W Bush, a Republican, then reappointed Greenspan in 2004.You can see that the Federal Reserve has extraordinary independence for a gov-ernment agency Nonetheless, the Fed is not free from political pressures Indeed, to understand the Fed’s behavior, we must recognize that public support for the actions of the Federal Reserve plays a very important role.3

shOuld The fed Be indePendenT?

As we have seen, the Federal Reserve is probably the most independent government agency in the United States; this is also true for central banks in most other countries Every few years, the question arises in Congress whether the independence given the Fed should

be curtailed Politicians who strongly oppose a Fed policy often want to bring it under their supervision, to impose a policy more to their liking Should the Fed be independent, or would we be better off with a central bank under the control of the president or Congress?

2 Similarly, William McChesney Martin, Jr., the chairman from 1951 to 1970, was appointed by President man (Dem.) but was reappointed by Presidents Eisenhower (Rep.), Kennedy (Dem.), Johnson (Dem.), and Nixon (Rep.) Also, Paul Volcker, the chairman from 1979 to 1987, was appointed by President Carter (Dem.) but was reappointed by President Reagan (Rep.) Ben Bernanke was appointed by President Bush (Rep.), but was reappointed by President Obama (Dem.).

Tru-3 To get a further inside view of how the Fed has interacted with the public and the politicians, see Bob Woodward,

Maestro: Greenspan’s Fed and the American Boom (New York: Simon and Schuster, 2000) and David Wessel, In Fed

We Trust (Random House: NY, 2009).

Inside the Fed How Bernanke’s Style Differs from Greenspan’s

Every Federal Reserve chairman has a different style

that affects how policy decisions are made at the Fed

There has been much discussion of how the current

chairman of the Fed, Ben Bernanke, differs from Alan

Greenspan, who was the chairman of the Federal

Reserve Board for nineteen years from 1987 until 2006

Alan Greenspan dominated the Fed like no other

prior Federal Reserve chairman His background was

very different from that of Bernanke, who spent most of

his professional life in academia at Princeton University

Greenspan, a disciple of Ayn Rand, is a strong advocate

for laissez-faire capitalism and headed a very

success-ful economic consulting firm, Townsend-Greenspan

Greenspan has never been an economic theorist, but

is rather famous for immersing himself in the data—

literally so, because he is known to have done this in

his bath tub at the beginning of the day—and often

focused on rather obscure data series to come up

with his forecasts As a result, Greenspan did not rely

exclusively on the Federal Reserve Board staff’s forecast

in making his policy decisions A prominent example

occurred during 1997, when the Board staff was

fore-casting a surge in inflation, which would have required

a tightening of monetary policy Yet Greenspan believed

that inflation would not rise and convinced the FOMC

not to tighten monetary policy Greenspan proved to

be right and was dubbed the “maestro” by the media

Bernanke, on the other hand, before going to

Wash-ington as a governor of the Fed in 2002, and then as

the chairman of the Council of Economic Advisors in

2005, and finally back to the Fed as chairman in 2006,

spent his entire career as a professor, first at Stanford

University’s Graduate School of Business, and then in

the Economics Department at Princeton University,

where he became chairman Because Bernanke did not

make his name as an economic forecaster, the Board

staff’s forecast now plays a much greater role in

deci-sion making at the FOMC In contrast to Greenspan,

Bernanke’s background as a top academic economist

has meant that he focuses on analytics in making his

decisions The result is a much greater use of model

simulations in guiding policy discussions

The style of policy discussions has also changed

with the new chairman Greenspan exercised extensive

control of the discussion at the FOMC During the

Greenspan era, the discussion was formal, with each

participant speaking after being put on a list by the secretary of the FOMC Under Bernanke, there is more give and take Bernanke has encouraged so-called two-handed interventions When a participant wants to go out of turn to ask a question or make a point about something that one of the other participants has just said, they raise two hands and are then acknowledged

by chairman Bernanke and called on to speak

The order of the discussion at the FOMC has also changed in a very subtle, but extremely important way Under Greenspan, after the other FOMC participants had expressed their views on the economy, Greenspan would present his views on the state of the economy and then would make a recommendation for what monetary policy action should be taken This required that the other participants would then just agree or disagree with the chairman’s recommendation in the following round of discussion about monetary policy In contrast, Bernanke usually does not make a recommendation for monetary policy immediately after other FOMC par-ticipants have expressed their views on the economy Instead, he summarizes what he has heard from the other participants, makes some comments of his own, and then waits until after he has heard the views of all the other participants about monetary policy before making his policy recommendation The process under Greenspan meant that the chairman was pretty much making the decision about policy, whereas Bernanke’s procedure is more democratic and enables participants

to have greater influence over the chairman’s vote.Another big difference in style is in terms of transpar-ency Greenspan was famous for being obscure, and even quipped at a Congressional hearing, “I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.” Bernanke is known for being a particularly clear speaker Although advances in transparency were made under Greenspan,

he adopted more transparent communication tantly Bernanke has been a much stronger supporter of transparency, having advocated that the Fed announce its inflation objective (see Chapter 16), and having launched a major initiative in 2006 to study Federal Reserve communications that resulted in substantial increases in Fed transparency in November 2007 (as discussed in the Inside the Fed box, “The Evolution of the Fed’s Communication Strategy,” on page 318)

the Case for Independence

The strongest argument for an independent central bank rests on the view that subjecting

it to more political pressures would impart an inflationary bias to monetary policy In the view of many observers, politicians in a democratic society are shortsighted because they are driven by the need to win their next election With this as the primary goal, they are unlikely to focus on long-run objectives, such as promoting a stable price level Instead, they will seek short-run solutions to problems, such as high unemployment and high interest rates, even if the short-run solutions have undesirable long-run consequences For example, we saw in Chapter 5 that high money growth might lead initially to a drop

in interest rates but might cause an increase later as inflation heats up Would a Federal Reserve under the control of Congress or the president be more likely to pursue a policy

of excessive money growth when interest rates are high, even though it would ally lead to inflation and even higher interest rates in the future? The advocates of an independent Federal Reserve say yes They believe that a politically insulated Fed is more likely to be concerned with long-run objectives and thus be a defender of a sound dollar and a stable price level

eventu-A variation on the preceding argument is that the political process in eventu-America could

lead to a political business cycle, in which just before an election, expansionary

poli-cies are pursued to lower unemployment and interest rates After the election, the bad effects of these policies—high inflation and high interest rates—come home to roost, requiring contractionary policies that politicians hope the public will forget before the next election There is some evidence that such a political business cycle exists in the United States, and a Federal Reserve under the control of Congress or the president might make the cycle even more pronounced

Putting the Fed under the control of the Treasury (making it more subject to ence by the president) is also considered dangerous because the Fed can be used to facilitate Treasury financing of large budget deficits by its purchases of Treasury bonds.4

influ-Treasury pressure on the Fed to “help out” might lead to more inflation in the economy

An independent Fed is better able to resist this pressure from the Treasury

Another argument for central bank independence is that control of monetary policy

is too important to leave to politicians, a group that has repeatedly demonstrated a lack

of expertise at making hard decisions on issues of great economic importance, such as reducing the budget deficit or reforming the banking system Another way to state this argument is in terms of the principal–agent problem discussed in Chapters 8, 9, and 11 Both the Federal Reserve and politicians are agents of the public (the principals), and both politicians and the Fed have incentives to act in their own interest rather than in the interest of the public The argument supporting Federal Reserve independence is that the principal–agent problem is worse for politicians than for the Fed because politi-cians have fewer incentives to act in the public interest

Indeed, some politicians may prefer to have an independent Fed, which can be used as a public “whipping boy” to take some of the heat off their backs It is possible that a politician who in private opposes an inflationary monetary policy will be forced

to support such a policy in public for fear of not being reelected An independent Fed can pursue policies that are politically unpopular yet in the public interest

4 The Federal Reserve Act prohibited the Fed from buying Treasury bonds directly from the Treasury (except to roll over maturing securities); instead, the Fed buys Treasury bonds on the open market One possible reason for this prohibition is consistent with the foregoing argument: The Fed would find it harder to facilitate Treasury financing

of large budget deficits.

the Case against Independence

Proponents of a Fed under the control of the president or Congress argue that it

is undemocratic to have monetary policy (which affects almost everyone in the economy) controlled by an elite group responsible to no one The current lack of accountability of the Federal Reserve has serious consequences: If the Fed performs badly, no provision is in place for replacing members (as there is with politicians) True, the Fed needs to pursue long-run objectives, but elected officials of Congress vote on long-run issues also (foreign policy, for example) If we push the argument further that policy is always performed better by elite groups like the Fed, we end

up with such conclusions as the Joint Chiefs of Staff should determine military budgets or the IRS should set tax policies with no oversight from the president or Congress Would you advocate this degree of independence for the Joint Chiefs or the IRS?

The public holds the president and Congress responsible for the economic well-being of the country, yet they lack control over the government agency that may well be the most important factor in determining the health of the economy

In addition, to achieve a cohesive program that will promote economic stability, monetary policy must be coordinated with fiscal policy (management of govern-ment spending and taxation) Only by placing monetary policy under the control

of the politicians who also control fiscal policy can these two policies be prevented from working at cross-purposes

Another argument against Federal Reserve independence is that an independent Fed has not always used its freedom successfully The Fed failed miserably in its stated role as lender of last resort during the Great Depression, and its independence cer-tainly didn’t prevent it from pursuing an overly expansionary monetary policy in the 1960s and 1970s that contributed to rapid inflation in this period

Our earlier discussion also suggests that the Federal Reserve is not immune from political pressures Its independence may encourage it to pursue a course of narrow self-interest rather than the public interest

No consensus has yet been reached on whether central bank independence is a good thing, although public support for independence of the central bank seems to have been growing in both the United States and abroad As you might expect, people who like the Fed’s policies are more likely to support its independence, while those who dislike its policies advocate a less independent Fed

Central Bank Independence and Macroeconomic performance throughout the World

We have seen that advocates of an independent central bank believe that economic performance will be improved by making the central bank more inde-pendent Empirical evidence seems to support this conjecture: When central banks are ranked from least independent to most independent, inflation performance

macro-is found to be the best for countries with the most independent central banks Although a more independent central bank appears to lead to a lower inflation rate, this is not achieved at the expense of poorer real economic performance Countries with independent central banks are no more likely to have high unem-ployment or greater output fluctuations than countries with less independent central banks

exPlAining CenTrAl BAnk BehAviOr

One view of government bureaucratic behavior is that bureaucracies serve the public interest (this is the public interest view) Yet some economists have developed

a theory of bureaucratic behavior that emphasizes other factors influencing how bureaucracies operate The theory of bureaucratic behavior suggests that the objective

of a bureaucracy is to maximize its own welfare, just as a consumer’s behavior is motivated by the maximization of personal welfare and a firm’s behavior is moti-vated by the maximization of profits The welfare of a bureaucracy is related to its power and prestige Thus this theory suggests that an important factor affecting a central bank’s behavior is its attempt to increase its power and prestige

What predictions does this view of a central bank like the Fed indicate? One is that the Federal Reserve will fight vigorously to preserve its autonomy, a prediction verified time and time again as the Fed has continually counterattacked congressional attempts to control its budget In fact, it is extraordinary how effectively the Fed has been able to mobilize a lobby of bankers and business people to preserve its inde-pendence when threatened

Another prediction is that the Federal Reserve will try to avoid conflict with powerful groups that might threaten to curtail its power and reduce its autonomy The Fed’s behavior may take several forms One possible factor explaining why the Fed is sometimes slow to increase interest rates and thus smooth out their fluctuations is that it wishes to avoid a conflict with the president and Congress over increases in interest rates The desire to avoid conflict with Congress and the president may also explain why in the past the Fed has not embraced trans-parency (see the Inside the Fed box, “The Evolution of the Fed’s Communication Strategy”)

The desire of the Fed to hold as much power as possible also explains why it ously pursued a campaign to gain control over more banks The campaign culminated

vigor-in legislation that expanded jurisdiction of the Fed’s reserve requirements to all banks

(not just the member commercial banks) by 1987

The theory of bureaucratic behavior seems applicable to the Federal Reserve’s actions, but we must recognize that this view of the Fed as being solely concerned with its own self-interest is too extreme Maximizing one’s welfare does not rule out altruism (You might give generously to a charity because it makes you feel good about yourself, but in the process you are helping a worthy cause.) The Fed is surely concerned that it conduct monetary policy in the public interest However, much uncertainty and disagreement exist over what monetary policy should be.5 When it is unclear what is in the public interest, other motives may influence the Fed’s behav-ior In these situations, the theory of bureaucratic behavior may be a useful guide to predicting what motivates the Fed and other central banks

5 One example of the uncertainty over how best to conduct monetary policy was discussed in Chapter 3: mists are not sure how to measure money So even if economists agreed that controlling the quantity of money is the appropriate way to conduct monetary policy (a controversial position, as we will see in later chapters), the Fed cannot be sure which monetary aggregate it should control.

Econo-Inside the Fed The Evolution of the Fed’s Communication Strategy

As the theory of bureaucratic behavior predicts, the

Fed has incentives to hide its actions from the public

and from politicians to avoid conflicts with them In

the past, this motivation led to a penchant for secrecy

in the Fed, about which one former Fed official

remarked that “a lot of staffers would concede that

[secrecy] is designed to shield the Fed from political

oversight.”* For example, the Fed pursued an active

defense of delaying its release of FOMC directives to

Congress and the public However, as we have seen,

in 1994 it began to reveal the FOMC directive

imme-diately after each FOMC meeting In 1999, it also

began to immediately announce the “bias” toward

which direction monetary policy was likely to go, later

expressed as the balance of risks in the economy In

2002, the Fed started to report the roll call vote on the

federal funds rate target taken at the FOMC meeting

In December 2004, it moved up the release date of the

minutes of FOMC meetings to three weeks after the

meeting from six weeks, its previous policy

The Fed has increased its transparency in recent

years, but has been slower to do so than many other

central banks One important trend toward greater

transparency is the announcement by a central bank

of a specific numerical objective for inflation, often

referred to as an inflation target, which will be

dis-cussed in Chapter 16 Alan Greenspan was strongly

opposed to the Fed’s moving in this direction, but

Chairman Bernanke is much more favorably

dis-posed, having advocated the announcement of a

specific numerical inflation objective in his writings

and in a speech that he gave as a governor in 2004.†

In November 2007, the Bernanke Fed announced

major enhancements to its communication strategy

First, the forecast horizon for the FOMC’s projections

under “appropriate policy” for inflation,

unemploy-ment, and GDP growth, which were mandated by the

Humphrey-Hawkins legislation in 1978, was extended from two calendar years to three, with long-run projec-tions added in 2009 Because projections for inflation given appropriate policy should converge to the desired inflation objective eventually, the longer-run projec-tions provide more information about what individual FOMC participants think should be the objective for inflation This change therefore moves the FOMC closer

to specifying a numerical objective for inflation Second, the Committee now publishes these projections four times a year rather than twice a year Third, the release

of the projections now includes narrative describing FOMC participants’ views of the principal forces shap-ing the outlook and the sources of risks to that outlook Although these enhancements to Fed communication are major steps forward, there are strong arguments that further increases in transparency could improve the control of inflation by anchoring inflation expectations more firmly, and also help stabilize economic fluctua-tions.** Indeed in October 2010,‡ Chairman Bernanke proposed moving in this direction, but he was unable

to get the FOMC to agree to it However, in 2011, the Fed announced a further move toward increased transparency: after the FOMC meetings in April, June, November and January, the Chairman of the Federal Reserve will now give a press conference intended to further enhance the clarity and timeliness of the Federal Reserve’s monetary policy communication

*Quoted in “Monetary Zeal: How the Federal Reserve Under Volcker Finally Slowed Down Inflation,” Wall Street Journal, December 7, 1984, p 23.

†Ben S Bernanke, “Inflation Targeting,” Federal Reserve Bank of St Louis

Review 86, no 4 (July/August 2004):165–168.

**Frederic S Mishkin, “Whither Federal Reserve Communications,” speech at the Petersen Institute for International Economics, July 28, 2008, http://www federalreserve.gov/newsevents/speech/mishkin20080728a.htm.

‡Ben S Bernanke, “Monetary Policy Objectives and Tools in a Low-Inflation Environment,” speech at the Revisiting Monetary Policy in a Low-Inflation Environment Conference, Federal Reserve Bank of Boston, Boston, Massachu- setts, October 15, 2010, http://www.federalreserve.gov/newsevents/speech/ bernanke20101015a.htm.

sTruCTure And indePendenCe Of The eurOPeAn

CenTrAl BAnk

Until recently, the Federal Reserve had no rivals in terms of its importance in the central banking world However, this situation changed in January 1999 with the start-up of the

European Central Bank (ECB) and European System of Central Banks (ESCB), which now conduct monetary policy for countries that are members of the European Monetary Union These countries, taken together, have a population that exceeds that of the United States and a GDP comparable to that of the United States The Maastricht Treaty, which estab-lished the ECB and ESCB, patterned these institutions after the Federal Reserve, in that central banks for each country (referred to as National Central Banks, or NCBs) have a simi-

lar role to that of the Federal Reserve Banks The European Central Bank, which is housed

in Frankfurt, Germany, has an Executive Board that is similar in structure to the Board of Governors of the Federal Reserve; it is made up of the president, the vice president, and four other members, who are appointed to eight-year, nonrenewable terms The Governing Council, which comprises the Executive Board and the presidents of the National Central Banks, is similar to the FOMC and makes the decisions on monetary policy While the presidents of the National Central Banks are appointed by their countries’ governments, the members of the Executive Board are appointed by a committee consisting of the heads

of state of all the countries that are part of the European Monetary Union

Differences Between the european System of Central Banks and the Federal reserve System

In the popular press, the European System of Central Banks is usually referred to as the European Central Bank (ECB), even though it would be more accurate to refer to it as the Eurosystem, just as it would be more accurate to refer to the Federal Reserve System

rather than the Fed Although the structure of the Eurosystem is similar to that of the Federal Reserve System, some important differences distinguish the two First, the budg-ets of the Federal Reserve Banks are controlled by the Board of Governors, whereas the National Central Banks control their own budgets and the budget of the ECB in Frank-

furt The ECB in the Eurosystem therefore has less power than does the Board of nors in the Federal Reserve System Second, the monetary operations of the Eurosystem are conducted by the National Central Banks in each country, so monetary operations are not centralized as they are in the Federal Reserve System Third, in contrast to the Federal Reserve, the ECB is not involved in supervision and regulation of financial insti-tutions; these tasks are left to the individual countries in the European Monetary Union

Gover-governing Council

Just as there is a focus on meetings of the FOMC in the United States, there is a similar focus in Europe on meetings of the Governing Council, which gathers monthly at the ECB in Frankfurt to make decisions on monetary policy Currently, seventeen countries are members of the European Monetary Union, and the head of each of the seventeen National Central Banks has one vote in the Governing Council; each of the six Executive Board Members also has one vote In contrast to FOMC meetings, which staff from both the Board of Governors and individual Federal Reserve Banks attend, only the twenty-three members of the Governing Council attend the meetings, with no staff present.The Governing Council has decided that although its members have the legal right

to vote, no formal vote will actually be taken; instead, the Council operates by sus One reason the Governing Council has decided not to take votes is because of wor-ries that the casting of individual votes might lead the heads of National Central Banks

consen-to support a monetary policy that would be appropriate for their individual countries, but not necessarily for the countries in the European Monetary Union as a whole This problem is less severe for the Federal Reserve: Although Federal Reserve Bank presidents

do live in different regions of the country, all have the same nationality and are more likely to take a national view in monetary policy decisions rather than a regional view.Just as the Federal Reserve releases the FOMC’s decision on the setting of the policy interest rate (the federal funds rate) immediately after the meeting is over, the ECB does the same after the Governing Council meeting concludes (announcing the target for a similar short-term interest rate for interbank loans) However, whereas the Fed simply releases a statement about the setting of the monetary policy instruments, the ECB goes further by having a press conference in which the president and vice president of the ECB take questions from the news media Holding such a press conference so soon after the meeting is tricky because it requires the president and vice president to be quick on their feet in dealing with the press The first president of the ECB, Willem F Duisenberg, put his foot in his mouth at some of these press conferences, and the ECB came under some sharp criticism His successor, Jean-Claude Trichet, a more successful communicator, has encountered fewer problems in this regard.

Although currently only seventeen countries in the European Monetary Union have representation on the Governing Council, this situation is likely to change in the future Three countries in the European Community already qualify for entering the European Monetary Union: the United Kingdom, Sweden, and Denmark Seven other countries

in the European Community (the Czech Republic, Hungary, Latvia, Lithuania, Poland, Bulgaria, and Roumania) might enter the European Monetary Union once they qualify, which may not be too far in the distant future The possible expansion of membership

in the Eurosystem presents a particular dilemma The current size of the Governing Council (twenty-three voting members) is substantially larger than the FOMC (twenty-three members) Many commentators have wondered whether the Governing Coun-cil is already too unwieldy—a situation that would get considerably worse as more countries join the European Monetary Union To deal with this potential problem, the Governing Council decided on a complex system of rotation, somewhat like that for the FOMC, in which National Central Banks from the larger countries will vote more often than National Central Banks from the smaller countries

how Independent Is the eCB?

Although the Federal Reserve is a highly independent central bank, the Maastricht Treaty, which established the Eurosystem, has made the latter the most independent central bank in the world Like the Board of Governors, the members of the Execu-tive Board have long terms (eight years), while heads of National Central Banks are required to have terms at least five years long Like the Fed, the Eurosystem determines its own budget, and the governments of the member countries are not allowed to issue instructions to the ECB These elements of the Maastricht Treaty make the ECB highly independent

The Maastricht Treaty specifies that the overriding, long-term goal of the ECB is price stability, which means that the goal for the Eurosystem is more clearly specified than it is for the Federal Reserve System However, the Maastricht Treaty did not specify exactly what “price stability” means The Eurosystem has defined the quantitative goal for monetary policy to be an inflation rate slightly less than 2%, so from this perspec-tive, the ECB is slightly less goal-independent than the Fed The Eurosystem is, how-ever, much more goal-independent than the Federal Reserve System in another way: The Eurosystem’s charter cannot be changed by legislation; it can be changed only by revision of the Maastricht Treaty—a difficult process because all signatories to the treaty

must agree to accept any proposed change

sTruCTure And indePendenCe Of OTher fOreign

CenTrAl BAnks

Here we examine the structure and degree of independence of three other important foreign central banks: the Bank of Canada, the Bank of England, and the Bank of Japan

Bank of Canada

Canada was late in establishing a central bank: The Bank of Canada was founded in

1934 Its directors are appointed by the government to three-year terms, and they appoint the governor, who has a seven-year term A governing council, consisting of the four deputy governors and the governor, is the policy-making body comparable to the FOMC that makes decisions about monetary policy

The Bank Act was amended in 1967 to give the ultimate responsibility for monetary policy to the government So on paper, the Bank of Canada is not as instrument-independent

as the Federal Reserve In practice, however, the Bank of Canada does essentially control monetary policy In the event of a disagreement between the bank and the government, the minister of finance can issue a directive that the bank must follow However, because the directive must be in writing and specific and applicable for a specified period, it is unlikely that such a directive would be issued, and none has been to date The goal for monetary policy, a target for inflation, is set jointly by the Bank of Canada and the government, so the Bank of Canada has less goal independence than the Fed

Bank of england

Founded in 1694, the Bank of England is one of the oldest central banks The Bank Act

of 1946 gave the government statutory authority over the Bank of England The Court (equivalent to a board of directors) of the Bank of England is made up of the governor and two deputy governors, who are appointed for five-year terms, and sixteen non-executive directors, who are appointed for three-year terms

Until 1997, the Bank of England was the least independent of the central banks examined in this chapter because the decision to raise or lower interest rates resided not within the Bank of England but with the Chancellor of the Exchequer (the equivalent

of the U.S Secretary of the Treasury) All of this changed when a new Labour ment came to power in May 1997 and the Chancellor of the Exchequer, Gordon Brown, made a surprise announcement that the Bank of England would henceforth have the power to set interest rates However, the Bank was not granted total instrument inde-pendence: The government can overrule the Bank and set rates “in extreme economic circumstances” and “for a limited period.” Nonetheless, as in Canada, because over-ruling the Bank would be so public and is supposed to occur only in highly unusual circumstances and for a limited time, it is likely to be a rare occurrence

govern-Because the United Kingdom is not a member of the European Monetary Union, the Bank of England makes its monetary policy decisions independently from the European Central Bank The decision to set interest rates resides in the Monetary Policy Committee, made up of the governor, two deputy governors, two members appointed

by the governor after consultation with the chancellor (normally central bank officials), plus four outside economic experts appointed by the chancellor (Surprisingly, two of the four outside experts initially appointed to this committee were not British citizens—one was Dutch and the other American—and some later appointments have also not been British citizens.) The inflation target for the Bank of England is set by the Chancel-lor of the Exchequer, so the Bank of England is also less goal-independent than the Fed

Bank of Japan

The Bank of Japan (Nippon Ginko) was founded in 1882 during the Meiji Restoration Monetary policy is determined by the Policy Board, which is composed of the governor; two vice-governors; and six outside members appointed by the cabinet and approved

by the parliament, all of whom serve for five-year terms

Until recently, the Bank of Japan was not formally independent of the ment, with the ultimate power residing with the Ministry of Finance However, the Bank of Japan Law, which took effect in April 1998 and was the first major change

govern-in the powers of the Bank of Japan govern-in 55 years, changed this situation In addition

to stipulating that the objective of monetary policy is to attain price stability, the law granted greater instrument and goal independence to the Bank of Japan Before this, the government had two voting members on the Policy Board, one from the Ministry

of Finance and the other from the Economic Planning Agency Now the ment may send two representatives from these agencies to board meetings, but they

govern-no longer have voting rights, although they do have the ability to request delays in monetary policy decisions In addition, the Ministry of Finance lost its authority to oversee many operations of the Bank of Japan, particularly the right to dismiss senior officials However, the Ministry of Finance continues to have control over the part

of the Bank’s budget that is unrelated to monetary policy, which might limit its pendence to some extent

inde-the trend toward greater Independence

As our survey of the structure and independence of the major central banks indicates, in recent years we have been seeing a remarkable trend toward increasing independence

It used to be that the Federal Reserve was substantially more independent than almost all other central banks, with the exception of those in Germany and Switzerland Now the newly established European Central Bank is far more independent than the Fed, and greater independence has been granted to central banks like the Bank of England and the Bank of Japan, putting them more on a par with the Fed, as well as to central banks in such diverse countries as New Zealand, Sweden, and the euro nations Both theory and experience suggest that more independent central banks produce better monetary policy, thus providing an impetus for this trend

Summary

1. The Federal Reserve System was created in 1913 to

lessen the frequency of bank panics Because of

pub-lic hostility to central banks and the centralization of

power, the Federal Reserve System was created with

many checks and balances to diffuse power

2. The structure of the Federal Reserve System consists of

twelve regional Federal Reserve banks, around 2,500

member commercial banks, the Board of Governors of

the Federal Reserve System, the Federal Open Market

Committee (FOMC), and the Federal Advisory Council

Although on paper the Federal Reserve System appears

to be decentralized, in practice it has come to function

as a unified central bank controlled by the Board of Governors, especially the board’s chairman

3. The Federal Reserve is more independent than most agencies of the U.S government, but it is still subject to political pressures because the legislation that structures the Fed is written by Congress and can be changed at any time

4. The case for an independent Federal Reserve rests on the view that curtailing the Fed’s independence and subjecting it to more political pressures would impart

an inflationary bias to monetary policy An independent

Fed can afford to take the long view and not respond

to short-run problems that will result in expansionary

monetary policy and a political business cycle The case

against an independent Fed holds that it is undemocratic

to have monetary policy (so important to the public)

controlled by an elite that is not accountable to the

pub-lic An independent Fed also makes the coordination of

monetary and fiscal policy difficult

5. The theory of bureaucratic behavior suggests that

one factor driving central banks’ behavior might be

an attempt to increase their power and prestige This

view explains many central bank actions, although

central banks may also act in the public interest

6. The European System of Central Banks has a similar

structure to the Federal Reserve System, with each

member country having a National Central Bank, and

an Executive Board of the European Central Bank being

located in Frankfurt, Germany The Governing Council, which is made up of the six members of the Executive Board (which includes the president of the European Central Bank) and the presidents of the National Cen-tral Banks, makes the decisions on monetary policy The Eurosystem, which was established under the terms of the Maastricht Treaty, is even more indepen-dent than the Federal Reserve System because its char-ter cannot be changed by legislation Indeed, it is the most independent central bank in the world

7. There has been a remarkable trend toward increasing independence of central banks throughout the world Greater independence has been granted to central banks such as the Bank of England and the Bank of Japan in recent years, as well as to other central banks

in such diverse countries as New Zealand and Sweden Both theory and experience suggest that more inde-pendent central banks produce better monetary policy

Key terms

Board of Governors of the Federal

Reserve System, p 304

easing of monetary policy, p 310

federal funds rate, p 308

Federal Open Market Committee (FOMC), p 304

Federal Reserve banks, p 303goal independence, p 312

instrument independence, p 312open market operations, p 306political business cycle, p 315tightening of monetary policy, p 310

Questions

All questions are available in MyEconLab at

1 Why was the Federal Reserve System set up with

twelve regional Federal Reserve banks rather than one

central bank, as in other countries?

2 Why is the Twelfth Federal Reserve district so

geograph-ically large, while the Second Federal Reserve district is

so small by comparison?

3 Should the Federal Reserve redraw its district

boundar-ies, similar to how congressional districts are periodically

realigned? Why or why not?

4 “The Federal Reserve System resembles the U.S

Con-stitution in that it was designed with many checks and

balances.” Is this statement true, false, or uncertain?

Explain your answer

5 Which entities in the Federal Reserve System control

the discount rate? Reserve requirements? Open market operations?

6 In what ways can the regional Federal Reserve Banks

influence the conduct of monetary policy?

7 Why is it important for the regional Federal Reserve

bank presidents to attend the FOMC meetings, even if they are nonvoting members?

8 Why is the New York Federal Reserve always a voting

member on the FOMC?

9 The presidents of each of the district Federal Reserve

banks (including the New York Federal Reserve bank) are currently not required to undergo a formal political appointment and approval process Do you think this

is appropriate? Why or why not?

10 Do you think that the fourteen-year nonrenewable

terms for governors effectively insulate the Board of

Governors from political pressure?

11 Despite the important role that the Board of Governors

has in setting monetary policy, seats to serve on the

Board of Governors can sometimes be empty for several

years How could this happen?

12 How is the president of the United States able to exert

influence over the Federal Reserve?

13 Why is it unlikely that the policy recommendation put

forth by the chairman of the Board of Governors would

ever be voted down by the rest of the FOMC?

14 How does the Federal Reserve have a high degree of

instru-ment independence? If it has a specific mandate from

Con-gress to achieve “maximum employment and low, stable

prices,” then how does the Fed have goal independence?

15 The Fed is the most independent of all U.S

govern-ment agencies What is the main difference between it

and other government agencies that explains the Fed’s

greater independence?

16 What is the primary tool that Congress uses to exercise

some control over the Fed?

17 Should the Federal Reserve be subject to periodic auditing

of its policies, procedures, and finances? Why or why not?

18 In the 1960s and 1970s, the Federal Reserve

Sys-tem lost member banks at a rapid rate How can the theory of bureaucratic behavior explain the Fed’s cam-paign for legislation to require all commercial banks

to become members? Was the Fed successful in this campaign?

19 “The theory of bureaucratic behavior indicates that the

Fed never operates in the public interest.” Is this ment true, false, or uncertain? Explain your answer

20 Why might eliminating the Fed’s independence lead to

a more pronounced political business cycle?

21 “The independence of the Fed leaves it completely

unaccountable for its actions.” Is this statement true, false, or uncertain? Explain your answer

22 “The independence of the Fed has meant that it takes

the long view and not the short view.” Is this ment true, false, or uncertain? Explain your answer

23 The Fed promotes secrecy by not releasing the minutes

of the FOMC meetings to Congress or the public diately Discuss the arguments for and against this policy

24 Which is more independent, the Federal Reserve or the

European Central Bank? Why?

25 Why did the Bank of England up until 1997 have a

low degree of independence?

Web exercises

1 Go to www.federalreserve.gov/ and click on About the

Fed Next click on The Federal Reserve System and

then on Structure According to the Federal Reserve,

what is the most important responsibility of the Board

of Governors?

2 Go to the previous site and click on Monetary Policy Then click on Reports and then go on Beige Book According to the summary of the most recently published book, is the economy weakening or strengthening?

Web references

www.federalreserve.gov/pubs/frseries/frseri.htm

Information on the structure of the Federal Reserve System

www.federalreserve.gov/otherfrb.htm

Addresses and phone numbers of Federal Reserve Banks,

branches, and RCPCs and links to the main pages of the

twelve reserve banks and Board of Governors

www.federalreserve.gov/bios/boardmembership.htm

Lists all the members of the Board of Governors of the

Fed-eral Reserve since its inception

www.federalreserve.gov/fomc

Find general information on the FOMC; its schedule of

meetings, statements, minutes, and transcripts; information

on its members; and the “beige book.”

As we saw in Chapter 5 and will see in later chapters on monetary theory,

move-ments in the money supply affect interest rates and inflation and thus affect us all Because of its far-reaching effects on economic activity, it is important to understand how the money supply is determined Who controls it? What causes it to change? How might control of it be improved? In this and subsequent chapters, we answer these questions by providing a detailed description of the money supply process,

the mechanism that determines the level of the money supply

Because deposits at banks are by far the largest component of the money supply, learning how these deposits are created is the first step in understanding the money supply process This chapter provides an overview of how the banking system creates deposits, and describes the basic principles of the money supply, needed as a founda-tion for later chapters

Three PlAyers in The Money suPPly Process

The “cast of characters” in the money supply story is as follows:

1 The central bank—the government agency that oversees the banking system and is

responsible for the conduct of monetary policy; in the United States, the Federal Reserve System

2 Banks (depository institutions)—the financial intermediaries that accept deposits

from individuals and institutions and make loans: commercial banks, savings and loan associations, mutual savings banks, and credit unions

3 Depositors—individuals and institutions that hold deposits in banks

Of the three players, the central bank—the Federal Reserve System—is the most tant The Fed’s conduct of monetary policy involves actions that affect its balance sheet (holdings of assets and liabilities), to which we turn now

impor-The Fed’s BAlAnce sheeT

The operation of the Fed and its monetary policy involve actions that affect its ance sheet, its holdings of assets and liabilities Here we discuss a simplified balance

bal-325

The Money supply Process

Preview

14

1 A detailed discussion of the Fed’s balance sheet and the factors that affect the monetary base can be found in the appendix to this chapter, which you can find on this book’s website at www.aw.com/mishkin.

2 It is also safe to ignore the Treasury’s monetary liabilities when discussing the monetary base because the Treasury cannot actively supply its monetary liabilities to the economy due to legal restrictions.

3 The currency item on our balance sheet refers only to currency in circulation—that is, the amount in the hands

of the public Currency that has been printed by the U.S Bureau of Engraving and Printing is not automatically

a liability of the Fed For example, consider the importance of having $1 million of your own IOUs printed You give out $100 worth to other people and keep the other $999,900 in your pocket The $999,900 of IOUs does not make you richer or poorer and does not affect your indebtedness You care only about the $100 of liabilities from the $100 of circulated IOUs The same reasoning applies for the Fed in regard to its Federal Reserve notes For similar reasons, the currency component of the money supply, no matter how it is defined, includes only currency in circulation It does not include any additional currency that is not yet in the hands of the public The fact that currency has been printed but is not circulating means that it is not anyone’s asset or liability and thus cannot affect anyone’s behavior Therefore, it makes sense not to include it in the money supply.

sheet that includes just four items that are essential to our understanding of the money supply process.1

Federal Reserve System

Securities Loans to financial institutions

Currency in circulation Reserves

monetary base When discussing the monetary base, we will focus only on the

monetary liabilities of the Fed because those of the Treasury account for less than 10% of the base.2

1 Currency in circulation The Fed issues currency (those green-and-gray pieces of

paper in your wallet that say “Federal Reserve Note” at the top) Currency in circulation

is the amount of currency in the hands of the public Currency held by depository institutions is also a liability of the Fed, but is counted as part of the reserves

Federal Reserve notes are IOUs from the Fed to the bearer and are also liabilities, but unlike most, they promise to pay back the bearer solely with Federal Reserve notes; that is, they pay off IOUs with other IOUs Accordingly, if you bring a $100 bill to the Federal Reserve and demand payment, you will receive either two $50s, five $20s, ten

$10s, or one hundred $1 bills

People are more willing to accept IOUs from the Fed than from you or me because Federal Reserve notes are a recognized medium of exchange; that is, they are accepted as a means of payment and so function as money Unfortunately, neither you nor I can convince people that our IOUs are worth anything more than the paper they are written on.3

2 Reserves All banks have an account at the Fed in which they hold deposits

Reserves consist of deposits at the Fed plus currency that is physically held by banks

(called vault cash because it is stored in bank vaults) Reserves are assets for the banks

but liabilities for the Fed, because the banks can demand payment on them at any time and the Fed is required to satisfy its obligation by paying Federal Reserve notes As you will see, an increase in reserves leads to an increase in the level of deposits and hence

in the money supply

Total reserves can be divided into two categories: reserves that the Fed requires

banks to hold (required reserves) and any additional reserves the banks choose to hold (excess reserves) For example, the Fed might require that for every dollar of

deposits at a depository institution, a certain fraction (say, 10 cents) must be held as

reserves This fraction (10%) is called the required reserve ratio.

assets

The two assets on the Fed’s balance sheet are important for two reasons First, changes

in the asset items lead to changes in reserves and the monetary base, and consequently

to changes in the money supply Second, because these assets (government securities and Fed loans) earn higher interest rates than the liabilities (currency in circulation, which pays no interest, and reserves), the Fed makes billions of dollars every year—its assets earn income, and its liabilities cost practically nothing Although it returns most

of its earnings to the federal government, the Fed does spend some of it on “worthy causes,” such as supporting economic research

1 Securities This category of assets covers the Fed’s holdings of securities issued

by the U.S Treasury and, in unusual circumstances (as discussed in Chapter 15), other securities As you will see, the primary way the Fed provides reserves to the banking system is by purchasing securities, thereby increasing its holdings of these assets An increase in government or other securities held by the Fed leads to an increase in the money supply

2 Loans to financial institutions The second way the Fed can provide reserves to the

banking system is by making loans to banks and other financial institutions For these institutions, the loans they have taken out are referred to as borrowings from the Fed or,

alternatively, as borrowed reserves These loans appear as a liability on financial

institu-tions’ balance sheets An increase in loans to financial institutions can also be the source

of an increase in the money supply During normal times, the Fed makes loans only to banking institutions and the interest rate charged banks for these loans is called the

discount rate (As we will discuss in Chapter 15, during the recent financial crisis,

the Fed made loans to other financial institutions.)

conTrol oF The MoneTAry BAse

The monetary base (also called high-powered money) equals currency in circulation C

plus the total reserves in banking system R.4 The monetary base MB can be expressed as

MB 5 C 1 R

4 Here, currency in circulation includes both Federal Reserve currency (Federal Reserve notes) and Treasury rency (primarily coins).

cur-The Federal Reserve exercises control over the monetary base through its purchases or

sales of securities in the open market, called open market operations, and through

its extension of discount loans to banks

Federal reserve Open Market Operations

The primary way in which the Fed causes changes in the monetary base is through its

open market operations A purchase of bonds by the Fed is called an open market purchase, and a sale of bonds by the Fed is called an open market sale.

million of bonds from banks and pays for them with a check for this amount To stand what occurs as a result of this transaction, we look at T-accounts, which list only

under-the changes that occur in balance sheet items, starting from under-the initial balance sheet sition The bank will either deposit the check in its account with the Fed or cash it in for currency, which will be counted as vault cash Either action means that banks will find themselves with $100 million more reserves and a reduction in its holdings of securities

po-of $100 million The T-account for the banking system, then, is

The Fed, meanwhile, finds that its liabilities have increased by the additional $100 million of reserves, while its assets have increased by the $100 million of additional securities that it now holds Its T-account is

The net result of this open market purchase is that reserves have increased by

$100 million, the amount of the open market purchase Because there has been

no change of currency in circulation, the monetary base has also risen by $100 million

happens when there is an open market purchase from the nonbank public, we must look at two cases First, let’s assume that the people or corporations that sell $100 mil-lion of bonds to the Fed deposit the Fed’s checks in their local banks The nonbank public’s T-account after this transaction is

When banks receive the checks, they credit depositors’ accounts with the $100 million and then deposit the checks in their account with the Fed, thereby adding to their reserves The banking system’s T-account becomes

Federal Reserve System

The effect on the Fed’s balance sheet is that it has gained $100 million of securities in its assets column, whereas it has an increase of $100 million of reserves in its liabilities column:

As you can see in the above T-account, when the Fed’s check is deposited in a bank, the net result of the Fed’s open market purchase from the nonbank public is identical

to the effect of its open market purchase from a bank: Reserves increase by the amount

of the open market purchase, and the monetary base increases by the same amount

If, however, the people or corporations selling the bonds to the Fed cash the Fed’s checks either at a local bank or at a Federal Reserve bank for currency, the effect on reserves is different.5 This sellers will receive currency of $100 million while reducing holdings of securities by $100 million The nonbank public’s seller’s T-account will be

5 If bond sellers cash checks at their local banks, the banks’ balance sheets will be unaffected, because the $100 million of vault cash that they pay out will be exactly matched by the deposits of the $100 million in checks at the Fed Thus banks’ reserves will remain the same, and their T-accounts will not be affected That is why a T-account for the banking system does not appear here.

The Fed now finds that it has exchanged $100 million of currency for $100 million of securities, so its T-account is

The net effect of the open market purchase in this case is that reserves are unchanged, whereas currency in circulation increases by the $100 million of the open market purchase Thus the monetary base increases by the $100 million amount of the open market purchase, while reserves do not This contrasts with the situation in which sellers of the bonds deposit the Fed’s checks in banks; in that case, reserves increase by $100 million, and so does the monetary base

The analysis reveals that the effect of an open market purchase on reserves depends

on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits If the proceeds are kept in currency, the open market purchase has no effect

on reserves; if the proceeds are kept as deposits, reserves increase by the amount of the open market purchase

The effect of an open market purchase on the monetary base, however, is always the same (the monetary base increases by the amount of the purchase) whether the seller of the bonds keeps the proceeds in deposits or in currency The impact of an open

market purchase on reserves is much more uncertain than its impact on the monetary base

public, the monetary base will decrease by $100 million For example, if the Fed sells bonds to individuals who pay for them with currency, the buyers exchange $100 million

of currency for $100 million of bonds, and the resulting T-account is

The Fed, for its part, has reduced its holdings of securities by $100 million and has also lowered its monetary liability by accepting the currency as payment for its bonds, thereby reducing the amount of currency in circulation by $100 million:

Federal Reserve System

The effect of the open market sale of $100 million of bonds is to reduce the monetary base by an equal amount, although reserves remain unchanged Manipulations of T-accounts in cases in which buyers of the bonds are banks or buyers pay for the bonds with checks written on a checkable deposit account at a local bank lead to the same

$100 million reduction in the monetary base, although the reduction occurs because the level of reserves has fallen by $100 million

The following conclusion can now be drawn from our analysis of open market

pur-chases and sales: The effect of open market operations on the monetary base is much

more certain than the effect on reserves Therefore, the Fed can control the monetary

base with open market operations more effectively than it can control reserves

Open market operations can also be done in other assets besides government bonds and have the same effects on the monetary base we have described here

Shifts from Deposits into Currency

Even if the Fed does not conduct open market operations, a shift from deposits to rency will affect the reserves in the banking system However, such a shift will have

cur-no effect on the monetary base, acur-nother reason why the Fed has more control over the monetary base than over reserves

Let’s suppose that during the Christmas season, the public wants to hold more rency to buy gifts and so withdraws $100 million in cash The effect on the T-account

cur-of the nonbank public is

Banking System

The banking system loses $100 million of deposits and hence $100 million of reserves:

For the Fed, the public’s action means that $100 million of additional currency is circulating in the hands of the public, while reserves in the banking system have fallen

by $100 million The Fed’s T-account is

The net effect on the monetary liabilities of the Fed is a wash; the monetary base is fected by the public’s increased desire for cash But reserves are affected Random fluctua-tions of reserves can occur as a result of random shifts into currency and out of deposits, and vice versa The same is not true for the monetary base, making it a more stable variable.

unaf-Loans to Financial Institutions

In this chapter so far, we have seen how changes in the monetary base occur as a result

of open market operations However, the monetary base is also affected when the Fed makes a loan to a financial institution When the Fed makes a $100 million loan to the First National Bank, the bank is credited with $100 million of reserves from the proceeds of the loan The effects on the balance sheets of the banking system and the Fed are illustrated by the following T-accounts:

The monetary liabilities of the Fed have now increased by $100 million, and the monetary base, too, has increased by this amount However, if a bank pays off a loan from the Fed, thereby reducing its borrowings from the Fed by $100 million, the T-accounts of the banking system and the Fed are as follows:

The net effect on the monetary liabilities of the Fed, and hence on the monetary base, is a reduction of $100 million We see that the monetary base changes one-for-one with the change in the borrowings from the Fed

Other Factors that affect the Monetary Base

So far in this chapter, it seems as though the Fed has complete control of the monetary base through its open market operations and loans to financial institutions However, the world is a little bit more complicated for the Fed Two important items that affect the monetary base, but are not controlled by the Fed, are float and Treasury deposits at the Fed When the Fed clears checks for banks, it often credits the amount of the check

to a bank that has deposited it (increases the bank’s reserves) before it debits (decreases

Federal Reserve System

Loans(borrowings from the Fed)

+$100 m

Federal Reserve System

Loans(borrowings from the Fed)

+$100 m Reserves +$100 m

the reserves of) the bank on which the check is drawn The resulting temporary net increase in the total amount of reserves in the banking system (and hence in the mon-

etary base) occurring from the Fed’s check-clearing process is called float When the

U.S Treasury moves deposits from commercial banks to its account at the Fed, leading

to an increase in Treasury deposits at the Fed, it causes a deposit outflow at these banks

like that shown in Chapter 10 and thus causes reserves in the banking system and the monetary base to decrease Thus float (affected by random events such as the weather,

which influences how quickly checks are presented for payment) and Treasury deposits

at the Fed (determined by the U.S Treasury’s actions) both affect the monetary base

but are not controlled by the Fed at all Decisions by the U.S Treasury to have the Fed intervene in the foreign exchange market also affect the monetary base

Overview of the Fed’s ability to Control the Monetary Base

Our discussion above indicates that two primary features determine the monetary base: open market operations and lending to financial institutions Whereas the amount of open market purchases or sales is completely controlled by the Fed’s placing orders with dealers in bond markets, the central bank cannot unilaterally determine, and therefore cannot perfectly predict, the amount of borrowings from the Fed The Federal Reserve sets the discount rate (interest rate on loans to banks), and then banks make decisions about whether to borrow The amount of lending, though influenced by the Fed’s set-ting of the discount rate, is not completely controlled by the Fed; banks’ decisions play

a role, too

Therefore, we might want to split the monetary base into two components: one that the Fed can control completely and another that is less tightly controlled The less tightly controlled component is the amount of the base that is created by loans from the

Fed The remainder of the base (called the nonborrowed monetary base) is under the

Fed’s control, because it results primarily from open market operations.6 The rowed monetary base is formally defined as the monetary base minus borrowings from

nonbor-the Fed, which are referred to as borrowed reserves:

tions Although float and Treasury deposits with the Fed undergo substantial

short-run fluctuations, which complicate control of the monetary base, they do not prevent the Fed from accurately controlling it.

6 Actually, other items on the Fed’s balance sheet (discussed in the appendix on the website) affect the magnitude

of the nonborrowed monetary base Because their effects on the nonborrowed base relative to open market tions are both small and predictable, these other items do not present the Fed with difficulties in controlling the nonborrowed base.

opera-MulTiPle dePosiT creATion: A siMPle Model

With our understanding of how the Federal Reserve controls the monetary base and how banks operate (Chapter 10), we now have the tools necessary to explain how deposits are created When the Fed supplies the banking system with $1 of additional

reserves, deposits increase by a multiple of this amount—a process called multiple deposit creation.

Deposit Creation: the Single Bank

Suppose that the $100 million open market purchase described earlier was conducted with the First National Bank After the Fed has bought the $100 million in bonds from the First National Bank, the bank finds that it has an increase in reserves of $100 mil-lion To analyze what the bank will do with these additional reserves, assume that the bank does not want to hold excess reserves because it earns little interest on them We begin the analysis with the following T-account:

Because the bank has no increase in its checkable deposits, required reserves remain the same, and the bank finds that its additional $100 million of reserves means that its excess reserves have risen by $100 million Let’s say that the bank decides to make a loan equal in amount to the $100 million rise in excess reserves When the bank makes the loan, it sets up a checking account for the borrower and puts the proceeds

of the loan into this account In this way, the bank alters its balance sheet by increasing its liabilities with $100 million of checkable deposits and at the same time increasing its assets with the $100 million loan The resulting T-account looks like this:

The bank has created checkable deposits by its act of lending Because checkable its are part of the money supply, the bank’s act of lending has, in fact, created money

depos-In its current balance sheet position, the First National Bank still has excess reserves and so might want to make additional loans However, these reserves will not stay at the bank for very long The borrowers took out loans not to leave $100 million sitting

First National Bank

idle in a checking account at the First National Bank but to purchase goods and services from other individuals and corporations When the borrowers make these purchases

by writing checks, the checks will be deposited at other banks, and the $100 million

of reserves will leave the First National Bank As a result, a bank cannot safely make

a loan for an amount greater than the excess reserves it has before it makes the loan.

The final T-account of the First National Bank is

The increase in reserves of $100 million has been converted into additional loans of

$100 at the First National Bank, plus an additional $100 million of deposits that have made their way to other banks (All the checks written on accounts at the First National Bank are deposited in banks rather than converted into cash, because we are assuming that the public does not want to hold any additional currency.) Now let’s see what hap-pens to these deposits at the other banks

Deposit Creation: the Banking System

To simplify the analysis, let’s assume that the $100 million of deposits created by First National Bank’s loan is deposited at Bank A and that this bank and all other banks hold

no excess reserves Bank A’s T-account becomes

If the required reserve ratio is 10%, this bank will now find itself with a $10 million increase in required reserves, leaving it $90 million of excess reserves Because Bank A (like the First National Bank) does not want to hold on to excess reserves, it will make loans for the entire amount Its loans and checkable deposits will then increase by $90 million, but when the borrowers spend the $90 million of checkable deposits, they and the reserves at Bank A will fall back down by this same amount The net result is that Bank A’s T-account will look like this:

If the money spent by the borrowers to whom Bank A lent the $90 million is deposited

in another bank, such as Bank B, the T-account for Bank B will be

The checkable deposits in the banking system have risen by another $90 million, for a total increase of $190 million ($100 million at Bank A plus $90 million at Bank B) In fact, the distinction between Bank A and Bank B is not necessary to obtain the same result on the overall expansion of deposits If the borrowers from Bank A write checks to someone who deposits them at Bank A, the same change in deposits would occur The T-accounts for Bank B would just apply to Bank A, and its checkable depos-its would increase by the total amount of $190 million

Bank B will want to modify its balance sheet further It must keep 10% of $90 million ($9 million) as required reserves and has 90% of $90 million ($81 million) in excess reserves and so can make loans of this amount Bank B will make loans totaling $81 million to borrowers, who spend the proceeds from the loans Bank B’s T-account will be

The $81 million spent by the borrowers from Bank B will be deposited in another bank (Bank C) Consequently, from the initial $100 million increase of reserves in the bank-ing system, the total increase of checkable deposits in the system so far is $271 million (=$100 m + $90 m + $81 m)

Following the same reasoning, if all banks make loans for the full amount of their excess reserves, further increments in checkable deposits will continue (at Banks C,

D, E, and so on), as depicted in Table 1 Therefore, the total increase in deposits from the initial $100 increase in reserves will be $1,000 million: The increase is tenfold, the reciprocal of the 10% (0.10) reserve requirement

If the banks choose to invest their excess reserves in securities, the result is the same If Bank A had taken its excess reserves and purchased securities instead of mak-ing loans, its T-account would have looked like this:

When the bank buys $90 million of securities, it writes $90 million in checks to the sellers of the securities, who in turn deposit the $90 million at a bank such as Bank B Bank B’s checkable deposits increase by $90 million, and the deposit expansion process

is the same as before Whether a bank chooses to use its excess reserves to make loans

or to purchase securities, the effect on deposit expansion is the same.

You can now see the difference in deposit creation for the single bank versus the ing system as a whole Because a single bank can create deposits equal only to the amount

bank-of its excess reserves, it cannot by itself generate multiple deposit expansion A single bank cannot make loans greater in amount than its excess reserves, because the bank will lose these reserves as the deposits created by the loan find their way to other banks However, the banking system as a whole can generate a multiple expansion of deposits, because when

a bank loses its excess reserves, these reserves do not leave the banking system, even though they are lost to the individual bank So as each bank makes a loan and creates deposits, the reserves find their way to another bank, which uses them to make additional loans and cre-ate additional deposits As you have seen, this process continues until the initial increase in reserves results in a multiple increase in deposits

The multiple increase in deposits generated from an increase in the banking

sys-tem’s reserves is called the simple deposit multiplier.7 In our example with a 10% required reserve ratio, the simple deposit multiplier is 10 More generally, the simple deposit multiplier equals the reciprocal of the required reserve ratio, expressed as a frac-tion (for example, 10 = 1/0.10), so the formula for the multiple expansion of deposits can be written as follows

Increase in Loans ($)

Increase in Reserves ($)

step-by-where ΔD = change in total checkable deposits in the banking system

rr = required reserve ratio (0.10 in the example)

Δ R = change in reserves for the banking system ($100 million in the example)

Deriving the Formula for Multiple Deposit Creation

The formula for the multiple creation of deposits can be derived directly using algebra

We obtain the same answer for the relationship between a change in deposits and a change in reserves

Our assumption that banks do not hold on to any excess reserves means that the total amount of required reserves for the banking system RR will equal the total reserves

in the banking system R:

The total amount of required reserves equals the required reserve ratio rr times the

total amount of checkable deposits D:

which is the same formula for deposit creation found in Equation 1.8

This derivation provides us with another way of looking at the multiple creation of deposits, because it forces us to examine the banking system as a whole rather than one bank at a time For the banking system as a whole, deposit creation (or contraction) will stop only when excess reserves in the banking system are zero; that is, the banking sys-tem will be in equilibrium when the total amount of required reserves equals the total amount of reserves, as seen in the equation RR = R When rr * D is substituted for RR, the resulting equation rr * D = R tells us how high checkable deposits will have to be

for required reserves to equal total reserves Accordingly, a given level of reserves in the banking system determines the level of checkable deposits when the banking system is

in equilibrium (when ER = 0); put another way, the given level of reserves supports a given level of checkable deposits

8 A formal derivation of this formula follows Using the reasoning in the text, the change in checkable deposits is

$100(= R * 1) plus $90 3= R * (1 - rr)4 plus $81 3= R * (1 - rr)2 4 , and so on, which can be rewritten as

D = R * 3 1 + (1 - rr) + (1 - rr)2 + (1 - rr)3 + g 4 Using the formula for the sum of an infinite series found in footnote 5 in Chapter 4, this can be rewritten as

D = R * 1 1

- (1 - rr)=

1

rr * R

In our example, the required reserve ratio is 10% If reserves increase by $100 lion, checkable deposits must rise by $1,000 million for total required reserves also to increase by $100 million If the increase in checkable deposits is less than this—say,

mil-$900 million—then the increase in required reserves of $90 million remains below the

$100 million increase in reserves, so excess reserves still exist somewhere in the ing system The banks with the excess reserves will now make additional loans, creating new deposits; this process will continue until all reserves in the system are used up, which occurs when checkable deposits rise by $1,000 million

bank-We can also see this by looking at the T-account of the banking system as a whole (including the First National Bank) that results from this process:

The procedure of eliminating excess reserves by loaning them out means that the banking system (First National Bank and Banks A, B, C, D, and so on) continues to make loans up to the $1,000 million amount until deposits have reached the $1,000 million level In this way, $100 million of reserves supports $1,000 million (ten times the quantity) of deposits

Critique of the Simple Model

Our model of multiple deposit creation seems to indicate that the Federal Reserve is able

to exercise complete control over the level of checkable deposits by setting the required reserve ratio and the level of reserves The actual creation of deposits is much less mechanical than the simple model indicates If proceeds from Bank A’s $90 million loan are not deposited but are kept in currency, nothing is deposited in Bank B and the deposit creation process ceases The total increase in the money supply is now the $90 million increase in currency plus the initial $100 million of deposits created by First National Bank’s loans, which were deposited at Bank A, for a total of only $190 million—consider-ably less than the $1,000 million we calculated with the simple model above Another way of saying this is that currency has no multiple deposit expansion, while deposits do Thus, if some proceeds from loans are not deposited in banks but instead are used to raise the holdings of currency, less multiple expansion occurs overall, and the money supply will not increase by as much as our simple model of multiple deposit creation tells us.Another situation ignored in our model is one in which banks do not make loans

or buy securities in the full amount of their excess reserves If Bank A decides to hold

on to all $90 million of its excess reserves, no deposits would be made in Bank B, and this would also stop the deposit creation process The total increase in deposits would

be only $100 million, not the $1,000 million increase in our example Hence, if banks choose to hold on to all or some of their excess reserves, the full expansion of deposits predicted by the simple model of multiple deposit creation again does not occur.Our examples indicate that the Fed is not the only player whose behavior influ-ences the level of deposits and therefore the money supply Depositors’ decisions

regarding how much currency to hold and banks’ decisions regarding the amount of excess reserves to hold also can cause the money supply to change.

FAcTors ThAT deTerMine The Money suPPly

Our critique of the simple model shows how we can expand on it to discuss all the tors that affect the money supply Let’s look at changes in each factor in turn, holding all other factors constant

fac-Changes in the Nonborrowed Monetary Base, MBn

As shown earlier in the chapter, the Fed’s open market purchases increase the rowed monetary base, and its open market sales decrease it Holding all other variables constant, an increase in MB n arising from an open market purchase raises the amount of the monetary base and reserves, so that multiple deposit creation occurs and the money supply increases Similarly, an open market sale that reduces MB n shrinks the amount

nonbor-of the monetary base and reserves, thereby causing a multiple contraction nonbor-of deposits

and a decrease in the money supply We have the following result: The money supply

is positively related to the nonborrowed monetary base MB n

Changes in Borrowed reserves, BR, from the Fed

An increase in loans from the Fed provides additional borrowed reserves, and thereby increases the amount of the monetary base and reserves, so that multiple deposit cre-ation occurs and the money supply expands If banks reduce the level of their discount loans, all other variables held constant, the monetary base and amount of reserves

would fall, and the money supply would decrease The result is this: The money supply

is positively related to the level of borrowed reserves, BR, from the Fed.

Changes in the required reserve ratio, rr

If the required reserve ratio on checkable deposits increases while all other variables, such as the monetary base, stay the same, we have seen that multiple deposit expansion

is reduced, and hence the money supply falls If, on the other hand, the required reserve ratio falls, multiple deposit expansion would be higher and the money supply would rise

We now have the following result: The money supply is negatively related to the

required reserve ratio rr In the past, the Fed sometimes used reserve requirements to

affect the size of the money supply In recent years, however, reserve requirements have become a less important factor in the determination of the money multiplier and the money supply, as we shall see in the next chapter

Changes in Currency holdings

As shown before, checkable deposits undergo multiple expansion, whereas currency does not Hence, when checkable deposits are converted into currency, holding the monetary base and other variables constant, a switch is made from a component of the money supply that undergoes multiple expansion to one that does not The overall level of multiple expansion declines and the money supply falls On the other hand, if