Ranjit Dighe
Lecture notes to accompany Mishkin's Chapter 14 ("Structure of Central Banks and the Federal Reserve System")
Note:  Some of this material actually goes with Chapter 15.  Revised 21-April-2004.

* In these notes:
I. Introducing the Federal Reserve: The monetary base and the Fed's three policy tools
II. The Fed's historical origins
III. Structure of the Fed
IV. Central bank independence


Virtually every country has a central bank of some kind, to be the government's banker and to regulate the supply of money and credit.  The U.S. central bank is the Federal Reserve System, or the Fed.  It is a network of 12 regional Federal Reserve banks in major U.S. cities, with additional branches in a couple dozen other cities.  The Fed's greatest power is concentrated in Washington, DC, where the Federal Reserve Board of Governors, headed by the Fed Chairman (now Alan Greenspan), is located.  Today the Fed is the most powerful economic policy-making institution, and its decisions on monetary policy and interest rates are watched intently by businesses, banks, and financial markets.

The Fed is a bank, with assets and liabilities to manage, but it is totally unlike any other U.S. bank.
-- It does not accept deposits, aside from commercial banks' reserve accounts and government deposits; instead, the vast majority of the Fed's liabilities are dollar bills, a.k.a. "Federal Reserve Notes" or "Currency in circulation."  U.S. currency is the Fed's liability because the Fed is responsible for maintaining the value of that currency by keeping inflation low.
-- On the asset side, unlike commercial banks, the Fed makes almost no loans, except emergency discount loans to banks facing cash shortages.  The vast majority of the Fed's assets are government securities, which the Fed buys and sells in order to affect the supply of bank reserves and the money supply.
-- The Fed's holdings of government securities are also important in that they provide the Fed with substantial interest income, more than enough to finance the Fed's operations.  The Fed's interest expenses on the liability side are virtually non-existent, because it does not pay interest on U.S. currency or on banks' reserve accounts.  Put that two facts together, and you get an enormously profitable bank; the Fed's charter, however, requires it to turn over all of its profits to the federal government.

As recently as the late 1990s, the Fed was more than twice as large as the largest U.S. bank.  A few big mergers later, that's no longer true, but the Fed still has more total assets than all but a few U.S. banks.  And no private bank begins to rival the Fed's ability to influence interest rates and the overall supply of credit.

The Fed influences the supply of credit, the money supply, and interest rates mainly by manipulating the supply of bank reserves. 
-- A related measure is the monetary base, which = currency + bank reserves.  The monetary base is also called high-powered money.  It is a crucial monetary measure, because the money supply is a multiple of the monetary base. In addition, while the banks and their depositors and borrowers play important roles in determining the size of the money supply, the monetary base is solely under the control of the Fed.  Increases in the monetary base are typically multiplied into much larger increases in the money supply.

The Fed controls the monetary base by controlling the level of bank reserves.  The Fed controls the level of reserves through its three policy tools:

(1) changing the banks' reserve requirements (currently 10% of checking deposits must be kept as reserves)
-- The Fed rarely changes these requirements, because it's too blunt a policy instrument, in that it could lead to excessive changes in the money supply and liquidity crunches at many banks.

(2) discount loans to banks
-- These fulfill the Fed's "lender of last resort" function. While not many banks actually take out such loans, in a period of financial crisis or recession the Fed may encourage banks to do so. The discount rate is the interest rate at which the Fed extends these discount loans to banks.  (Historically it was slightly lower than the federal funds rate, the overnight lending rate between banks, but that's no longer the case.  The discount rate in April 2004 is 2.00%, twice the federal funds rate target of 1.00%.)

* (3) OPEN MARKET OPERATIONS (buying and selling Treasury bonds from banks).
-- When the Fed buys a T bond from a bank or lends money to a bank, it increases the total of bank reserves, thereby increasing the monetary base. When the Fed sells a T bond to a bank, the bank pays the Fed by allowing the Fed to debit its reserve account, thereby decreasing the total of bank reserves and the monetary base.
-- This is by far the Fed's most commonly used policy tool, and is what the Fed uses to control the much-watched federal funds rate (the interest rate at which banks loan reserves to each other).


The U.S. began as a nation of small farmers, who feared centralized banking power and distrusted the "moneyed interests" in general. Banks were viewed in terms of what they did to you (hounded you for repayment of debts, took your farm away), not what they did for you. The early central banks, the first and second Banks of the United States, both lasted just 20 years.

Could the U.S. get along just fine without a central bank? Yes and no. The 19th century, in which the U.S. was mostly without a central bank, was a century of rapid U.S. economic growth, yet the U.S. economy in the years without a central bank (1837-1913) was a lot less stable than today's economy. Economic recessions (including a big one that began in 1837, the year that the second Bank of the United States was eliminated; long story there) were relatively common, as were severe episodes of deflation (falling prices, or negative inflation rates).
-- Q: What's wrong with deflation?
-- A: DEBT-DEFLATION EFFECT: Deflation is economically destabilizing, because it raises the real interest rate and hence the real burden of debt, causing indebted individuals and firms to retrench and, often, to go bankrupt.
---- (Side note: This effect was first noted by the great American economist Irving Fisher. It is the other Fisher effect.)
---- The debt-deflation effect sometimes turned recessions into depressions, since bankruptcies and loan defaults often have a ripple effect on creditors and on the economy in general.

Bank panics (runs on the bank, often leading to or coincident with depressions) were also common. Besides the Panic of 1837, there were major bank panics in 1857, 1873, 1884, 1893 (touched off second deepest depression in U.S. history), and 1907.

The Panic of 1907, though brief, was extremely severe -- real net national product fell by over 11 percent -- and was characterized by a substantial drop in the money supply, of about 7 percent. The public staged a run on the banks, and the banks themselves scrambled for liquidity, causing a dramatic "credit crunch." The banking panic may not have been the direct cause of the economic slump of 1907-1908, but it made it a lot more severe than it otherwise would have been. As severe as it was, if the contraction had occurred in the 19th century, it probably would not have spurred the government into action -- the government sat idly by during the depression of the 1890s, for example. But by 1907 the Progressive Era was well underway.
--> Congress responded with the Aldrich-Vreeland Act (1908), which tried to set up "national currency associations" of ten or more healthy banks apiece, which would issue emergency bank notes in times of crisis, thereby maintaining liquidity. The Act also established a National Monetary Commission, which issued a major report four years later, in 1912. The report said, "The methods by which our ... credit operations are conducted are crude, expensive, and unworthy of an intelligent people." The report proposed a central bank.
----> Congress passed the Federal Reserve Act in 1913, and President Woodrow Wilson signed it into law two days before Christmas.  The new Federal Reserve System began operations in 1914.

The Fed's charter was permanent, unlike the 20-year charters of the First and Second National Banks. It was to be a "lender of last resort" that could provide liquidity and credit in troubled times, so as to avert banking crises.


The Federal Reserve System (the Fed) is composed of the following:
-- the seven-member Federal Reserve Board of Governors in Washington, DC
---- There are seven Fed governors.  Each is appointed by the President to a 14-year term.
---- All seven Fed governors sit on the Fed's official policy-making group, the Federal Open Market Committee (FOMC), which has 12 members altogether.
-- 12 regional Federal Reserve Banks
---- Of the 12 regional Fed banks, the Federal Reserve Bank of New York is by far the most powerful. It conducts the Fed's open-market operations (buying and selling of securities so as to influence the money supply and interest rates) and its foreign-exchange transactions (designed to influence the dollar's exchange rate).
-- the several thousand member banks, i.e., commercial banks that are members of the Federal Reserve System.
-- [See Mishkin's Chapter 14, Figure 1, "Formal Structure and Allocation of Policy Tools in the Federal Reserve."]

The Fed Board of Governors are its central figures
-- seven members, appointed by the President and confirmed by the Senate
-- 14-year terms (no reappointment, usually not served out anyway)
-- Chairman (Alan Greenspan) has 4-year renewable term
-- they have a permanent voting majority on the FOMC
-- they also have the power to change the Fed's required reserve ratio for banks and to set the discount rate (the interest rate at which the Fed loans money to banks)

The Federal Open Market Committee (FOMC) is the Fed's policymaking group.
* it meets every six weeks to plot the course of monetary policy
* it decides what it wants the federal funds rate to be. Open-market operations (OMO) is its tool for reaching that target.
* it has 12 members -- the seven Fed Governors, the NY Fed President, and four other regional Fed Bank Presidents
* it sets targets for the federal funds rate, which are implemented by the NY Fed as OMO decisions.

Twelve regional Fed banks is probably 11 more than we actually need. Creating 12 regional Fed banks, instead of one powerful central bank, made more sense politically than economically. Given the American public's historical hostility to large and powerful banking interests, the framers of the Federal Reserve Act believed the Fed would be a lot more viable politically if it did not consolidate all its power in one large bank, say in Washington or New York. As such, the regionalization of the Fed was a political master-stroke.
-- [Refer to Mishkin's Chapter 14, Figure 2, which shows all of the Federal Reserve districts.]
---- The New York Fed district covers NY state and parts of CT and NJ. Other Fed districts include several whole states.
For example, the San Francisco Fed includes about one-fourth of the country's total land area.
---- Again, the most powerful of the regional Fed banks is the New York Fed. Its president has a permanent seat on the Federal Open Market Committee (FOMC, the Fed's policy-making group); in fact, the New York Fed president is always the Vice-Chairman of the FOMC.
---- Each regional Fed bank is a quasi-public institution (part private, part government-controlled) owned by the private commercial banks in its district. The private banks own stock in their Fed bank and elect six of its nine directors (the other three are appointed by the Fed Board of Governors in Washington). Each regional bank's directors appoints its president. The dividends on the regional Fed banks' stock are set at 6%.
------ By law, the Fed must turn over 100% of any excess profits (what's left after paying salaries, expenses, and those 6% dividends) to the federal government.

The functions of the 12 regional Feds are varied.
-- Some are mundane but important, like clearing checks, issuing new currency, and destroying old currency.
-- Some involve considerable judgment, like evaluating bank mergers and making discount loans to banks.
-- Some involve economic research and forecasting, as well as providing regional data and forecasts.
-- Finally, the regional Fed bank presidents participate in monetary policy decisions.
---- The New York Fed president and four other (rotating) regional Fed presidents sit on the Federal Open Market Committee (FOMC), the Fed's policy-making body. The FOMC also includes the seven members of the Fed's Board of Governors.

There are a few thousand member banks in the Federal Reserve System. They include:
-- all nationally chartered banks, some state-chartered banks
-- about 33% of commercial banks, down from 49% in 1947. Why the decline occurred: Fed reserve requirements have always been well in excess of what banks actually need to cover deposit outflows. Since the interest rate on bank reserves is zero, banks naturally don't want to keep a lot of reserves. Many banks found the opportunity cost of meeting the Fed's reserve requirements -- namely, the interest they could be earning by loaning out that money or putting it into securities -- was prohibitively high, so they opted out of the Federal Reserve System.
---- In 1980, in response to Fed concerns about declining membership, which lessened their control over monetary policy and hence inflation (over 10% at the time), Congress made all banks, including nonmember banks, subject to the Fed's reserve requirements. In return, all banks would have discount privileges (be able to take out loans) and check-clearing privileges at the Fed. The new laws (part of the Depository Institutions Deregulation and Monetary Control Act of 1980) stopped the decline in Fed membership, and lessened the distinction between member and nonmember banks. Part of the rationale for the new laws was that by keeping more banks within the Federal Reserve system, the Fed's control over monetary policy -- which seemed to be slipping away, as inflation rates had risen to over 10% by 1980 -- would be strengthened.

The Fed has become considerably more powerful over the course of this century. It was virtually impotent in the early years of the Great Depression of the 1930s, in part because the U.S. was then on the gold standard, a fixed-exchange-rate regime that essentially tied the Fed's hands. After the avalanche of bank failures in 1930-33, however, President Franklin D. Roosevelt took the U.S. off the gold standard in 1933 -- only then did the Fed gain the power to conduct the type of highly expansionary monetary policy that would be necessary to bring the country out of a major recession or depression.  The Fed became especially powerful in the 1980s, as Paul Volcker (who served as Fed Chairman from 1979-87) brought down inflation nearly single-handedly and President Reagan and Congress produced a steady stream of $200 billion deficits, effectively killing off fiscal policy as an option. Within the Fed, power has become consolidated within the Board of Governors and especially the Chairman. Volcker and Greenspan are perhaps the two most powerful Fed Chairs in history.


The Fed is technically an independent agency, as opposed to being part of the government. The Fed's revenues do not come from the government but from the interest they receive on their T-bonds and discount loans to banks; in that sense they are independent. In addition, Fed members cannot be fired or recalled by the President or the Senate before their terms are up.

The Fed's independent status raises a number of important questions -- in particular, how can a democratic society allow so much economic power to be concentrated in a group of unelected economists? Fed Chairman Alan Greenspan has far more
control over the U.S. economy than does the President of the U.S., or anyone else.
-- On the other hand, the Fed isn't completely removed from the political process. The Federal Open Market Committee (FOMC) is dominated by the Board of Governors, all of whom are appointed by one politician, the President, and confirmed by at least 51 more, in the Senate. The Fed Chairman is reappointed by the President every four years. Also, the Fed must turn over any profits it makes (mainly from interest income) to the federal government.

In addition, at least one Fed Chairman, Arthur Burns, has been criticized for short-sighted policies designed to help the incumbent President (Nixon) win re-election, at the cost of higher inflation later. The Burns-Nixon actions, in Nixon's first term (1969-73) were a classic case of a political business cycle, whereby the Fed uses monetary policy to make the economy peak at election time. In a political business cycle, the Fed practices contractionary monetary policy in the first two years of the President's term, so as to lower the (actual and expected) rate of inflation, and shift the Phillips Curve down, then practices expansionary economic policy in the next two years, so as to lower unemployment and produce strong GDP growth at election time. Since expansionary monetary policies tend to produce higher inflation only after a time lag of a year or two, the higher inflation comes after the President has already won re-election, paving the way for another monetary contraction (and a repetition of the political business cycle) in the early years of the President's second term.
-- Aside from the Nixon-Burns experience, political business cycles are very rare, perhaps even non-existent, in this country.

Arguments against the Fed's independence:
* Undemocratic -- puts too much power in the hands of unelected Fed Governors. Since the Fed tends to be dominated by Wall Street and bond-market interests, it tends to pursue overly tight monetary policies, keeping interest rates high and inflation low, which serves the interests of those Wall Street stock- and bondholders. This is the classic populist critique of the Fed.
* No provision to replace bad members
* Makes it difficult to coordinate fiscal and monetary policy. In the early 1980's, for example, the Fed continued its War on Inflation, which induced a severe recession, while Congress passed a tax cut aimed at promoting economic recovery. Until the Fed took its brakes off the economy in late 1982, the tax cut had no prayer of working.
* Fed has often blundered (impotent in Great Contraction of 1929-33, let inflation to get out of control in late 1960's and 1970's)

Arguments for the Fed's independence:
* Politicians may lack the economic expertise of Fed bankers.
* Inflationary bias to Fed policy if controlled by politicians, who may tend to favor short-run monetary expansions that lower unemployment and raise real income in an election year.
---- We would expect political business cycles to be a lot more common in countries where the central bank is controlled by politicians.
---- The Treasury may pressure Fed to buy new T-bonds, financed by printing new money. (This is called the "inflation tax," or "monetizing the debt"). This phenomenon is very common in Third World countries.
---- Since the Fed does not have to worry about re-election, it can pursue unpopular but wise policies. The Fed's 1979-82 "War on Inflation," under Chairman Paul Volcker, is cited by some people as an example of such a policy ("short-term pain for long-term gain").
---- An earlier international study found a definite pattern of higher inflation rates in 1973-88 in countries with non-independent central banks (Spain, New Zealand, Italy) as compared with countries with very independent central banks (U.S., Germany, Switzerland).

The Fed's independence today: The Fed remains highly independent, but for the most part maintains a good working relationship with Congress and the White House.
-- Paul Volcker and Alan Greenspan have gone out of their way to avoid even the appearance of doing too much to help incumbent Presidents win reelection. (Volcker, a Democrat, did nothing to help Jimmy Carter's re-election bid in 1980; likewise, Greenspan, a conservative Republican, did nothing to help George H.W. Bush's re-election bid in 1992.)
-- In the 1990s, despite the Fed's independence, Republican Alan Greenspan and Democratic President Bill Clinton enjoyed a productive working relationship.
-- In 2004, it's a bit of a different story, as Greenspan has been criticized by some (notably former Democratic presidential candidate Howard Dean) for being too cozy with President George W. Bush, such as endorsing his tax cuts.  Still, in this current election year the Fed is unlikely to be a factor.  Interest rates are so low that the Fed can hardly lower them further, and the economic recovery is still too precarious for an interest-rate increase to make sense.