Chapter 14: Central Bank Form and Function

Chapter Objectives• Define central bank and explain the importance of central banking.• Briefly sketch the history of U.S. central banking.• Explain when and how a country can do without a central bank.• Briefly sketch the structure of the Federal Reserve System. • Explain how other central banks compare to the Fed.• Define central bank independence and explain its importance. • Explain why independent central bankers prefer lower inflation rates than

government officials do.

1. America’s Central Banks

Roles of a Central BankA central bank is a bank under some degree of government control that is

generally charged with:• Controlling the money supply (to a greater or lesser degree)• Providing price stability (influencing the price level)• Attaining economic output and employment goals • Regulating commercial banks (and perhaps other depository and non-

depository financial institutions)• Stabilizing the macroeconomy (proactively and/or by acting as a lender of

last resort during financial crises)• Providing a payments system (check clearing and long distance payments)• Holding deposits and making payments for the national government

1. America’s Central Banks

In U.S. history1791-1811 Bank of the U.S.Regulated commercial banks and reserves, money supply; lender of last resort.Independence and regulatory power led to its charter not being renewed.

1816-1836 Second Bank of the U.S.Regulated commercial banks and reserves, money supply; lender of last resort.Independence and regulatory power led to its charter not being renewed.

1837-1914 No central bankRoles of government’s banker and clearinghouse private sectorRoles of bank regulation state governments and marketsRole of managing the money supply trade with fixed currency rates

(commodity money tied to gold)

1914-present Federal Reserve

1. America’s Central Banks

In GeneralNo need for central bank if:

• Fixed exchange rate currency trade controls money supply

• Use another currency outsource monetary policy

• Clearing done by private sector

• Regulation done by market, other government institution

• Lender of last resort private wealth

1. America’s Central Banks

In U.S. history1837-1914 No central bankRoles of government’s banker and clearinghouse private sector.Roles of bank regulation state governments and markets.Role of managing the money supply trade with fixed currency rates

(commodity money tied to gold)

Problems:• No official system-wide lender of last resort• Nobody to increase the money supply or lower

interest rates in response to a shock

1. America’s Central Banks

In U.S. history1907 Panic. Private wealth (Morgan) as lender of last

resort; fear of “money trust”

1913 Federal Reserve Act establishes Federal Reserve System

2. The Federal Reserve System’s Structure

The Federal Reserve is composed of twelve numbered districts, each with its own Federal Reserve Bank

12 Districts

Boston (1) New York (2)

Philadelphia (3) Cleveland (4) Richmond (5)

Atlanta (6) Chicago (7) St. Louis (8)

Minneapolis (9) Kansas City (10)

Dallas (11)

San Francisco (12)

2. The Federal Reserve System’s Structure

Owned (but not entirely controlled) by members in each district

• All nationally chartered commercial banks and any state banks

which choose to join • Members elect six district bank directors

– three professional bankers and – three nonbank business leaders

• Three directors appointed by The Board of Governors (Washington)

• The nine directors, with the consent of the Board, then appoint a president.

2. The Federal Reserve System’s Structure

Roles of the District Banks

• Issue new Federal Reserve Notes (FRNs) in place of worn currency• Clear checks• Lend to banks within their districts• Act as a liaison between the Fed and the business community• Collect data on regional business and economic conditions• Conduct monetary policy research• Evaluate bank merger and new activities applications• Examine bank holding companies and state-chartered member banks

2. The Federal Reserve System’s Structure

Roles of the Federal Reserve Bank of New York

• Conducts “open market operations” – buying/selling government bonds• Is a member of the Bank for International Settlements (BIS)• Safeguards over $100 billion in gold owned by the world’s major central

banks• The FRBNY’s president is the only permanent member of the Federal Open

Market Committee (FOMC)

2. The Federal Reserve System’s Structure

Roles of the Federal Open Market Committee

• Decides on monetary policy – growth of money supply– Fed funds target rate– Discount rate at which district banks lend directly to

member banks– Reserve requirements

2. The Federal Reserve System’s Structure

The Board of Governors

• 7 Governors– Appointed by the president of the United States and confirmed

by the U.S. Senate– Come from different Federal Reserve districts– Serve a single 14-year term

• Chairperson is selected from among the governors and serves a four-year, renewable term

2. The Federal Reserve System’s Structure

The Roles of the Fed’s economists*

• Provide the chairman and the FOMC with: – new data– qualitative assessment of economic trends– quantitative output from the latest macroeconomic models

• Examine the global economy• Analyze the foreign exchange market • Screen for possible shocks from abroad • Help the district banks to:

– investigate market and competition conditions– engage in educational and other public outreach programs

2. The Federal Reserve System’s Structure

The Roles of the Fed’s Chair

• Influences the money supply or a key interest rate • Effectively controls reserve requirements and the

discount rate• Is the Fed’s public face • Is its major liaison to the national government

3. Other Important Central Banks

Eurosystem structure (U.S. equivalent)

Chair

Executive Board (Board of

Governors)

National Central Banks (Districts)

Governing Council (FOMC)

3. Other Important Central Banks

The Bank of England1694 Royal Charter granted by the Tonnage ActFounded as a private corporation to be the banker for the British government1946 became a state-owned institution

4. Central Bank Independence

Factors of Independence

• Rule of law• Control of Budget

• Established by law or treaty• Appointed officials• Long terms of office

• Non-renewable terms of office

4. Central Bank Independence

Tougher on Inflation?

Central Banks

• Central banks represent banks and business

• Inflation hurts net creditors• Inflation increases interest rate

risk• Inflation creates uncertainty• Inflation slows investment• Inflation slows growth

Elected government

• Politicians represent net debtors• Higher interest rates that combat

inflation will cost them money and perhaps their job

• Fiscal or monetary stimulus encourages growth